As market volatility continues to build, there are various methods investors can deploy to protect portfolios.

Last week was another volatile ride for share market investors, who dislike volatility because wealth can be so quickly wiped away. Yet there are multiple ways to protect portfolios against volatility or even make money from market peaks and troughs.

With the re-emergence of volatility in early February and March, all eyes are on the key volatility index, the Chicago Board Options Exchange (CBOE) Volatility Index (VIX Index). Several days this year, the index, which measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices, has experienced sharp moves, including on 22 March, when it jumped 31 per cent to 23.35, contrast with the low volatility of last year.

One of the most popular ways to protect portfolios against volatility is through put options, a type of exchange-traded option (ETO), typically taken out where you think the market will fall. Put options can be bought over certain individual stocks or the S&P/ASX 200. They give the holder the right to sell a stock at that price. A put option locks in the sale price of your shares for the life of the option, no matter how far a share price or the index falls.

The ASX's senior manager of equity derivatives, Graham O'Brien, says a put option can be used for portfolio protection, whereby if you buy a put option on the S&P/ASX 200 (XJO), “it effectively gives you protection against a fall in the market.”

He notes that there was record open interest in options on XJO, with $77 billion in open options as at 22 March 2018.

After a spike in volatility in early February and on March 22, "we are seeing this interest because it is definitely something that people are concerned about and volatility can spike very quickly," says O’Brien.

Another less common way to protect portfolios is through listed warrants known as MINI Shorts. These operate like put options, in that the buyer will make money as the index falls. MINI Shorts enable investors to take a leveraged position and are typically issued by investment banks. Like put options, the most you can lose is your initial outlay.
For investors, another option to protect portfolios is to buy ‘inverse’ exchange traded funds. BetaShare’s inverse ETFs Australian Equities Bear Fund and Strong Bear Fund move in the opposite direction of the share market and can be used by traders looking to capitalise on market volatility, which is expected to be a feature of 2018.

“While funds under management remain steady at $100 million for both funds, it’s interesting to note that short term trading volumes pick up when volatility hits the market,” says ASX’s O’Brien.

“Their strong bear ETF turned over $65 million in February and when compared to the $83 million in funds under management for the fund, it had the highest turnover percentage of any Australian-based ETF. This suggests to me that traders have taken short-term positions to hopefully profit from short term market movements,” says O’Brien.

James Gerrish, senior investment adviser with Shaw and Partners, uses put options to make money from volatility for his clients, primarily over XJO.
“This allows you to trade volatility. You can do that with ETFs in the US or through the [listed] options market in Australia. But it is quite a sophisticated strategy, so you need to have your finger on the pulse,” he says.

“You can sell options in a non-volatile market, but you will get less income. Or you can sell options when volatility is high and you can make more money. But the risk is also greater,” says Gerrish, who favours index options over those on individual stocks.

“The probability that singular stocks have profit upgrades, downgrades, regulatory issues, management issues, etc., is quite high. On the other hand, if we think about the index, the 200 stocks that make up the ASX 200, by selling options against a basket of stocks, our exposure to each individual stock move is greatly reduced, which reduces the overall risk of the position,” says Gerrish. He adds that unlike in the US, there are not specific ETFs over the VIX Index.

The bad news for investors is that volatility is expected to increase in the months ahead. Vanguard's Investment Strategy Group is anticipating higher risks and lower returns over the near and medium term as easy monetary policy is unravelled around the globe. Add trade tensions triggered by US President Donald Trump, and markets are wobbly.
“Vanguard believes the increasing synchronisation of growth rates across major economies is setting the stage for central banks in the United States, Europe and elsewhere to begin rolling back some of the extraordinary policy measures enacted in the wake of the global financial crisis. The chance of economic jolts resulting from a return to "normal" monetary policy is high,” says the ETF provider in its Rising risks to the status quo economic outlook paper.

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Nicki Bourlioufas is a contributor for Morningstar Australia.

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