How to Use the Market's Volatility to Your Advantage
Anyone who has been watching the stock market over the past few weeks would likely agree that calling the current economic state volatile would be a gross understatement. Indeed, as the repercussions of quarantining and social distancing are rippling through our domestic businesses and international supply chain, there are many unanswered questions surrounding how profoundly this “new norm” will affect global commerce in the aftermath of the Coronavirus. To reflect this uncertainty, major stock indices have had their most dramatic swings since the Great Depression.
Being a finance major, I often get asked if this situation should be seen as an auspicious window to buy stock, which I can only answer circumstantially. As far as retirement funds go, it is indeed an excellent time to invest, since although the S&P can continue to sink precipitously, it will unfailingly rebound in the future. However, I also have some less risk-averse peers who would prefer to eschew safety for the potentiality of high short-term gains. For them, I do not believe that buying stocks is the best option. Nor would I advocate shorting equities, a transaction in which one makes money when the price of a stock drops. Although we can continue to expect dramatic price changes, there is little reliable indication as to which direction the market will trend towards in an intraday time frame.
There is a third option, and aptly enough, I am referring to a financial security called options. Options are not stocks themselves, but rather are contracts to buy and sell stocks at or before a particular time at a predetermined price, known otherwise as a strike. If somebody buys an options contract, it is known as a call, and if one sells a contract, it is a put. A call is profitable if the stock price exceeds its contracted strike. To put this simply, if you have a contract saying that you can buy stock X for $100, and the actual stock price is $150, you can exercise your option to purchase it at $50 below its market value. You would then be able to pocket this difference by selling the stocks at their market value. If the price never exceeds the strike, you simply do not exercise the contract, and only lose whatever fees you paid to enter it. Buying puts works similarly, except one profits when the stock price is lower than the strike.
If somebody were to purchase a put and call option simultaneously, they would profit if the stock’s price moved either above or below the strike as long as this movement was large enough to cover the fees associated with entering the contracts. Such a combination of contracts is known as a straddle spread, and rather than rewarding you for correctly guessing whether a stock should appreciate or decline in value, its profitability is contingent upon the market’s volatility. In other words, it does not matter which direction a stock moves in, but only by how much. Considering that short-term markets are the most volatile they have been for decades, there is no better time to create a straddle spread. While those directly buying or selling stock will continue to rely on guesswork for their short-term gains, you can exploit calculated risk and rare market conditions to turn profits far more reliably in the coming weeks.
