Market volatility: Understanding the drivers and how to navigate

Financial markets are inherently dynamic, with volatility that can unnerve even the most seasoned traders. To navigate turbulent periods, it’s crucial to understand the key drivers of market volatility, strategies to protect your positions and opportunities that arise during market dislocations. In this article, we’ll explore the VIX Index, the current market landscape, using defensive and offensive strategies while also considering the role of leverage in volatile markets.

The VIX Index

The VIX, or the CBOE’s Volatility Index, is a widely used measure of market volatility. It gauges the market’s expectation of 30-day forward-looking volatility based on S&P 500 index options. Higher VIX levels indicate increased market uncertainty and potential for price swings.

Source: Macrotrends

During times of market stress, the VIX can spike significantly. For example, this can be seen during the COVID-19 pandemic 2020 and the Global Financial Crises (GFC) in 2008. 

Current market landscape

The VIX is currently at relatively low levels. However, the current market landscape presents unique challenges and potential sources of volatility:

1. Central Bank actions: Many central banks, including the Federal Reserve and European Central Bank, are pricing in rate cuts this year. While this may provide short-term support, it could also fuel inflation and exacerbate debt levels already at record highs. The potential for a rise in inflationary expectations and the sustainability of debt levels could become sources of market volatility.

2. Geopolitical tensions: Ongoing geopolitical tensions, such as the recent Israel-Iran tensions, US-China trade relations, Russia-NATO tensions and Cyber attacks can create uncertainty and lead to sudden market movements.

3. Economic Recovery: As the world continues to recover from the COVID-19 pandemic, uneven economic growth, supply chain disruptions, and shifts in consumer behaviour may contribute to market volatility. Additionally, the increased acceptance of work-from-home (WFH) arrangements has the potential to impact various sectors, such as commercial real estate and technology, which could lead to sector-specific volatility.

Short-term Vs. Long-term Drivers

Market volatility can be driven by both short-term and long-term factors. Short-term drivers, such as earnings reports, economic data releases and geopolitical events, can cause sudden spikes in volatility. These drivers often have a more immediate impact on market sentiment but may not necessarily reflect long-term trends.

On the other hand, long-term drivers such as shifts in monetary policy, structural changes in the economy and demographic trends, can lead to more persistent periods of volatility. These drivers may not always result in immediate market reactions but can shape the overall market environment over an extended period. Traders must consider both when making investment decisions.

Defensive Vs. Offensive Strategies

When expectations of higher volatility are increasing, traders can employ a combination of defensive and offensive strategies to navigate market turbulence.

Defensive strategies are designed to protect portfolios from potential losses during volatile periods. These strategies include:

1. Portfolio rebalancing: Reallocating assets by selling some holdings and acquiring others can help manage risk during volatile periods. For example, traders may choose to sell growth stocks that are more sensitive to market fluctuations and buy defensive sectors such as utilities or consumer staples.

2. Portfolio trimming: Holding a portion of your portfolio in cash or dollar-backed digital assets allows for flexibility and opportunistic buying during market downturns. This strategy can help traders avoid selling assets at depressed prices during volatile periods.

3. Diversification: Spreading investments across different asset classes, sectors and geographies can help reduce the overall impact of market volatility.

4. Hedging: Using derivatives like put options or volatility-linked instruments can provide downside protection during volatile periods. For instance, buying put options on the S&P 500 index can help offset potential losses in a broader portfolio.

On the other hand, offensive strategies are designed to capitalise on market volatility and potentially generate profits during turbulent times. These strategies include: 

1. Dollar-cost averaging (DCA): Investing a fixed amount at regular intervals, regardless of market conditions, can help navigate volatility and potentially outperform market timing. For example, consistently buying a set amount of diverse index funds or ETFs can help mitigate the impact of short-term price fluctuations.

2. Long-term buying perspective: Maintaining a bird’s eye view of the market and buying solid assets during bear markets can position you for future upside. As the saying goes, “dumb money sells at the bottom, and smart money buys at the bottom.” By adopting a longer-term perspective, traders can weather until eventual market recovery.

3. Sector rotation: Identifying sectors that may benefit from the current market landscape, such as tech companies that support remote work and adjusting portfolio allocations accordingly.

4. Momentum Investing: This is identifying and investing in assets that are showing strong upward (or downward) price trends. 

The Importance of Identifying Potential Catalysts

While market volatility can be driven by various factors, it’s crucial to recognize the difference between orderly and disorderly exits. Disorderly exits are often related to the unwinding of leveraged debt or positions. Identifying potential tipping points and understanding their impact on market contagion is key to navigating volatility.

During the GFC in 2008-2009, the unwinding of leverage derivatives and Collateralized Debt Obligations (CDOs) played a significant role in triggering market volatility. Leading up to the crisis, banks had relaxed their lending standards, issuing a large number of subprime mortgages, often referred to as NINJA loans (No Income, No Job, No Assets), to borrowers with poor credit histories. These high-risk mortgages were then repackaged into CDOs and sold to investors (non-US banks also heavily participated in this process)

As the housing market began to decline, borrowers started defaulting on their mortgages. The value of the CDOs, which were heavily exposed to these subprime mortgages, plummeted, leading to significant losses for investors and financial institutions holding these leveraged positions. The unwinding of these positions led to a domino effect, causing a liquidity crisis and widespread market volatility.

In the COVID-19 market downturn of 2020, leverage was not as directly linked to the cause of the volatility as it was during the GFC. However the rapid spread of the virus and the resulting economic shutdowns led to a sharp decline in asset prices across various markets. This sudden drop in prices triggered margin calls for investors who had leveraged positions, forcing them to sell assets to meet these calls. The selling pressure exacerbated the market downturn, contributing to increased volatility. Additionally many companies faced liquidity challenges as their revenues declined sharply due to lockdowns and reduced economic activity. Companies with high levels of debt or leveraged found themselves in a precarious position, as they struggled to meet their financial obligations. The potential for corporate defaults and bankruptcies added to market uncertainty and volatility.

Source: Yahoo finance

More recently, the collapse of FTX, a major cryptocurrency exchange, in 2022 highlighted the potential for sector-specific volatility. The implosion of FTX led to a contagion effect in the crypto space, with many other crypto assets and related companies experiencing significant price declines. 

Source: Deriv

The recovery of the crypto market post-FTX highlights the importance of considering the long-term perspective and the market’s ability to bounce back demonstrates the complex dynamics at play. Amidst the chaos, traders who are able to navigate the challenges, can capitalise on the potential for growth and returns in the aftermath.

The Role of Leverage

Leverage, or the use of borrowed funds to increase trading positions can be a double-edged sword in volatile markets. When used wisely, leverage can amplify potential returns, allowing traders to capitalise on smaller price movements. However leverage also magnifies potential losses and during periods of high volatility, rapid price fluctuations can lead to significant losses if positions are not managed carefully.

Traders must exercise caution when using leverage in volatile markets and exercise patience in picking and spacing levels to leave enough dry powder for further opportunities.

Final Thoughts

Navigating market volatility requires a deep understanding of the key drivers, the current market landscape and the appropriate strategies to employ. By monitoring the VIX index, recognizing the distinction between short-term and long-term volatility drivers and implementing a balanced mix of defensive and offensive strategies, traders can better manage risk and capitalise on opportunities.

In the current market landscape, potential sources of new volatility include the real estate market, geopolitical tensions, technological change and the growing influence of social media on financial markets. Traders must stay vigilant, monitor these factors and understand the complex interplay between different market segments to anticipate and navigate sudden shifts.

Leverage can be a powerful tool in volatile markets, but it must be used cautiously. Traders should exercise patience, maintain a diversified portfolio and employ risk management techniques to weather periods of heightened volatility.

By staying informed, adaptable and maintaining a long-term perspective, traders can successfully navigate the challenges and capitalise on the opportunities presented by market volatility. While turbulent times may unnerve even the most seasoned traders, they also offer potential for significant growth and returns for those who are well-prepared and positioned to take advantage of the dynamic nature of financial markets.