Why volatility is a good thing

Advisors can capitalize on market volatility – but to do so, they must consider options beyond stocks and bonds, writes Michael Yeung

Why volatility is a good thing

Advisors can capitalize on market volatility – but to do so, they must consider options beyond stocks and bonds, writes Michael Yeung

When most people in the financial sector see a tweet from President Donald Trump promising a new string of tariffs on Chinese exports, the first response is a predictable groan, followed by the all-important question: How is this going to affect my portfolio? While my initial reaction might be similar, it’s also tinged with a hint of excitement – because volatility means opportunity when you have the right tools.

The issue that has been plaguing investors and traders recently is that with volatility coming from so many different directions, investing has become a game of reactive whack-a-mole instead of a situation for proactively using strategies and instruments to take advantage of volatility.

It’s becoming increasingly difficult to predict what the next headline is going to be, where it will come from and, importantly, how the markets are going to react. But the greater issue is that almost no asset classes are safe – stocks, bonds, currencies and commodities are all being battered. This has created a landscape where something as small as a single tweet can wipe out millions of dollars of market value in an instant.

So where can investors turn when their usual strategies are stymied by the latest headline? Somewhere they likely haven’t looked before.

Canadian investors have shied away from more speculative investment products, in part because for much of the past decade, simply sticking to stocks and bonds has led to strong returns with little risk. But now, as the record-setting bull run slows down, and with many economists predicting another recession on the horizon, it may be time to reconsider some of these products.

Derivatives and other leveraged products such as contracts for difference [CFDs], futures or options have a reputation for being riskier investments, given their use of leverage. However, this risk is mitigated by the fact that these products and the companies that offer them are highly regulated in Canada by IIROC and the OSC.

While stricter regulations on these products have hindered their path into the mainstream in North America, they are massively popular elsewhere in the world, notably throughout Europe and in Australia. Like other alternative products, derivatives are designed to offer traders more options to make efficient use of their capital by providing greater flexibility. In large part, the popularity of these products is due to a trader’s ability to trade on rising and falling markets, as well as easy access to the forex, commodity and index markets across the globe.

Because derivative products – and CFDs in particular – mimic the underlying index, commodity, forex or stock market, this means traders don’t own the instrument they’re trading. Instead, they agree to exchange the difference in price of the asset between their opening and closing positions with the broker. This, of course, affords the trader the flexibility of going long or short on various markets with relative ease, as the traded product is not actually owned.

Another attractive feature of derivatives and CFDs is the fact that instruments are traded on margin. A trader doesn’t have to spend nearly $1,500 upfront for an ounce of gold; instead, they would deposit anywhere between 3% and 5% of their total position size to take a long or short position on gold specifically. For every point the instrument moves in your direction, the more you earn; however, the same theory applies to your losses as well.

Overall, with a robust trading and risk management strategy, derivatives are not as daunting as they seem and can be a great way for traders to hedge their existing portfolio through periods of short-term volatility. While every economist, portfolio manager and advisor has their own view on when the next recession might hit, there is a growing consensus that it is coming. What this means for asset managers and traders globally is that what they’ve been doing for the past decade may not work for what comes next – so it might be time for them to consider some alternatives themselves before the next downturn arrives.

Michael Yeung is head of CMC Markets Canada. He has more than 12 years of experience within the self-directed investment industry, as well as 10-plus years of experience working with the CFD product in Canada.