How To Profit From Extreme Volatility

Includes: DIA, QQQ, SPY
by: Jeff Miller

The right move is so often the most difficult.

On a theoretical basis, everyone knows to buy when others are fearful, to be contrarian, to avoid panic.

On a practical basis, hardly anyone has the discipline and courage to act.

Here are three ways that the individual investor can profit from the current volatility. [Please note that I try very carefully to distinguish time frames. My regular weekly outlook was bearish last week, and remains so, on a short-term trading basis. I am still shopping aggressively for long-term investors, who should often take the opposite side from traders].

Method One -- Go Shopping

The most direct method for profit is to rely on fundamental analysis to determine value. Market fluctuations are opportunities. If the market is dominated by fear, so much the better!

Earlier this year I participated in the Abnormal Returns "vacation survey," a nice concept that allowed Tadas to have a few days off and still stimulate content that would not otherwise have been available. (There should be a term for that). My recommendation for the best book in the last five years?

Joel Greenblatt's The Little Book that (Still) Beats the Market is a great choice for investors. It is both educational and practical. It is short and easy to read, but difficult to follow in practice. Why? Most will not have the patience to stick with the system for the time required.

The author was featured on CNBC last Tuesday. He noted that trailing free cash flows were in the best 5% of any time in history. When this has happened in the past, the market has rallied by 15% in the next year and "value stocks" have rallied 30%. Check out the entire interview:

For long-term investors, I noted last Monday that there would soon be an attack on the promising news from Europe. Traders and pundits expect comprehensive and perfect solutions. This will play out gradually and with compromises.

Most of the so-called experts will hate it every step of the way -- until it is too late to see. So far, it is exactly as I expected.

Wednesday afternoon we bought stocks with the following characteristics:

  • A ten-year history of earnings growth, including 2008, 20% growth rate, 15 P/E
  • A company with over 30 years of consistent revenue growth
  • A company with a great balance sheet, solid dividend, and a P/E under 10

While I like to think we are finding the cream of the crop, there are so many candidates that any individual investor willing to do some homework can beat the market right now.

Method Two -- Sell Puts

Put selling has a bad rep! When I started in the business, leaving the quiet confines of Wisconsin academia in October of 1987, the market was charging higher. Selling puts (an option where you agree to buy the underlying stock at a set price during a set period of time) was being offered as a way of printing money. Since stocks always went higher (shades of the real estate market) you could sell puts with impunity. The stock would move higher, and you pocketed the premium! Easy money. I have a souvenier copy of Barron's from that week. On the day of the '87 crash, Barron's hit the newsstand with many ads for these bogus trading systems.

The rules changed, making put-selling more difficult for everyone, including the individual investor. You really need to know what you are doing.

With that warning in mind -- this is a strategy that can work. Here are the rules:

  • Pick a stock that you want to own based upon earnings, price, balance sheet, cash flow, and dividends.
  • Pick a price where you would love to buy the stock.
  • Sell a put at that price. You will collect the premium. If the stock trades below your price on expiration, you might get "assigned" on the stock -- which means you will buy at the price you set.
  • Prepare to be disappointed if the stock does not trade lower. You will still collect the premium.

This is a great way to play high-volatility opportunities.

Method Three -- Covered Calls

This is a great method to exploit volatility, but it starts with fundamental analysis:

  1. Find an attractive stock -- all of the value metrics described above.
  2. Look for a support level, either via a chart or your favorite technical analyst.
  3. Consider yield via dividends.
  4. Find an out-of-the money call that you can sell.

At a minimum you collect dividends, stock appreciation, and the call premium.

You have limited upside in a big rally. If the stock sells off, you have some protection from the call sale and the dividend.

This is the most conservative of the three approaches.

Investment Conclusion

Most individual investors read the headline news and panic. They do not see when to seize opportunity nor the best methods for doing so.

My snail mail last Wednesday had (yet another) offer to buy some gold company that had a field next to one that had already hit. This is only one example. We all know that these ads could not be paid for unless the companies involved were making big money.

I also have my "fear monger" spam filter. It is overstuffed with unsupported rumors, bad data, and politically charged messages. Maybe I'll do a post with some headlines.

This is a minefield for the individual investor -- even the most intelligent people who try to reason and interpret data.

It has never been more challenging to stay focused on the goal line.