How To Make The Most Of An Unsettled Market

How To Make The Most Of An Unsettled Market
Stéphane Renevier, CFA

almost 2 years ago6 mins

  • Volatile markets create plenty of challenges: you’ll need to consider when to sell, to manage your risk well, and to control your emotions.

  • But they also create opportunities: you could adjust to take a trader mindset, enter stocks at a better price, and test our your investing approach.

  • Alternatively, you could just… do nothing: it might be safer, after all.

Volatile markets create plenty of challenges: you’ll need to consider when to sell, to manage your risk well, and to control your emotions.

But they also create opportunities: you could adjust to take a trader mindset, enter stocks at a better price, and test our your investing approach.

Alternatively, you could just… do nothing: it might be safer, after all.

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Investors have been wrestling with a lot of pressing questions lately. How much will central banks raise rates, and how often? Where will inflation go from here? Will there be a recession? All of these uncertainties and more threaten to push today’s choppy markets into all-out volatility. And that’ll present you with challenges and opportunities alike…

What are the challenges?

Knowing when to sell

When markets are volatile, prices can move against your position extremely quickly, or they can hit the price target you’re targeting – only to swiftly retrace to where they were before. In either case, you’ll need to create an exit strategy in advance: a clear plan of action around when to cut your losses and when to take your profits.

In the first instance, I’d recommend setting up a stop-loss, which should inform you when the market breaches a certain price level. Just remember to position it far enough away from the current market price that short-term volatility doesn’t trigger it and lock you out of potential gains. A good rule of thumb is to put your stop-loss at least 3x below the average true range (ATR) – a technical analysis indicator that measures the volatility of a given market. Take the SPDR S&P 500 ETF Trust (SPY), which is currently trading at $457: its ATR is $8, meaning you should put the stop loss below at least $433.

As for how to secure your profits, you’ll either want to target a specific price level or use a trailing stop-loss. This tool can be particularly helpful when price swings are volatile and wide: as the price of your asset rises, it drags the stop-loss price at the same distance but to a new higher level. In other words, it lets you ride the wave up, while protecting you from a wipeout if the price falls precipitously.

Preparing for the unexpected

As Howard Marks once said, “Risk means more things can happen than will happen.”

And when a market is volatile, a lot can happen. So you should plan for the worst: prepare for the market’s price to drop to zero (or climb 500x if you’re holding a short position), for the exchange to go broke, for your stop-losses not be executed at the price you targeted (which can happen when the market “gaps” from one price to another), and for diversification to let you down.

With those extreme scenarios in mind, you can make sure you never get into a situation that could endanger your portfolio’s survival. So size your positions a lot more conservatively than you normally would, limit your leverage, and add a margin of safety when setting up your stop-losses. Oh, and always keep a healthy amount of cash on hand.

Getting better at controlling your emotions

Even if you take all the necessary precautions, your emotions will push you to do the wrong thing at the wrong time – like selling before you’ve reached your profit target, or maintaining your position in a stock that breached a stop-loss.

To reduce the impact of your emotions, make sure to put your thought processes down on paper. You could, for example, write the three conditions under which you’d close a position: the stop-loss has been hit, you’ve reached your profit target, or your reasons for investing have materially changed. Checklists can also help: review whether you’ve sold the stocks that have breached their stop-losses, and whether your thesis still holds up. Even something as simple as that will reduce the chance that you react with your heart, rather than with your head.

What are the opportunities?

Switching to a “trader” mentality

First, a caveat: you could leave your investments alone and sit out this volatility. Generally, that’s considered a smart choice for the majority of investors. You’ll miss out on some buying and selling opportunities, but you’ll avoid some costly mistakes.

But for those who aren’t happy on the sidelines, switching to a “trader” approach could lead to some strong rewards. Volatile markets are faster, tend to mean-revert (i.e. swing back up once they’ve experienced a big drop), and create short-term opportunities by creating divergences in prices versus their fundamentals. Traders tend to do well in a volatile environment because they’re quick to identify new opportunities, execute their trades in a way that maximizes their profits, and manage their positions in a way that allows them to make more on winning trades than they lose on the bad ones.

So if you want to adapt your mindset to this new environment, here are a few ways to do just that: shorten your time horizon, be willing to take a contrarian stance, and constantly be on the lookout for new, good value opportunities. Focus on execution as much as on idea generation, and try to make more when you win than you lose when you lose: let your winners run and cut your losses short.

Going shopping at discounted prices

A volatile market’s severe price drops can provide interesting buying opportunities for buy-and-hold and shorter-term investors alike – as long as you’re ready.

There are a few steps you can take to make sure you are. The first is to write a wishlist of stocks and other assets you like the look of, but consider too expensive at current prices. The second is to determine what price you’d no longer consider “too expensive”, and would consider buying in at. Alphabet, for example, might seem too expensive if it’s trading at 40x its earnings, but you might decide to buy in at a multiple of, say, 30x.

Finally, you’ll want to set up alerts or use limit orders, which automatically buy the asset once a specific price level is met. If you’re in no hurry to build a position in a stock, waiting until volatility pushes a market’s price past your buy target will reduce significantly your entry price.

Learning from your mistakes

Volatile markets might be the best opportunity you have to learn about trading, risk management, and your own psychology. It’ll really put your whole approach to the test, and you’ll probably make some mistakes along the way. But if you can learn from each of them, you’ll emerge stronger and shrewder for it.

The best way to learn from your mistakes is to keep a journal, writing detailed explanations for every action you take. Once a week or month, review your notes and try to understand what you did well and what you could do better. If, for example, you haven’t respected your plan, ask yourself: is it because you realized that your plan wasn’t good enough to begin with, or just because your emotions led you to deviate from it? Identify the strengths and weaknesses of your investment process, and use what you learn to gradually make it better.

But try not to be too hard on yourself: making money in volatile markets is difficult. But with perseverance, discipline, and an open mind, the lessons you learn might pave the way for your future success.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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