4 strategies to capitalize on market volatility

31 Oct 2023 , 05:44 PM

With the war between Israel and Palestine escalating, caution is the new buzzword in the investment world. The double whammy of spiraling crude oil prices as well as US-10Y bond yields has fueled outflows from emerging markets like India, leading to greater volatility in these markets. But the question now is – “Is market volatility a risk or an opportunity?”. Any seasoned stock market player would vouch by the opportunity veiled under market volatility. In fact, it is the ability of making the most of market volatility which separates the men from the boys in the world of investing.

First up, let us look at some simple facts. The Nifty 50 index is projected to achieve an EPS of Rs. 948 for the fiscal year 2024, indicating a one-year forward multiple of approximately 20 times. This is one standard deviation (SD) above its long-term average. Given the absence of substantial downgrades to Nifty’s fiscal year 2024 earnings at this point, we are maintaining our outlook for respectable returns in the index over the next 12 months. 

However, a look at historical trends indicate that we might need to temper our expectations. Let’s take the example of September 2017, when the index was trading around 1SD above its long term average, and gave a return of 13% in the next one year. Likewise, in October 2018, the index was at 1SD above the long term average and grew ~14% in the following 12 months. 

Now let us take a closer look at the denominator, i.e. earnings. At present, earnings of most large cap companies have come in line with the estimates. From here on, any positive surprises in the earnings of these companies could further boost earnings per share of the Nifty50 index. This, in turn, would drive the PE multiple towards the long-term average, making the valuation more attractive.

Recently released high frequency indicators (August/September) paint an encouraging picture of the Indian economy. These include continued strong momentum in the Industrial/Infra activity trends, strong ECB flows, favorable fiscal position and a very strong capex by the central and state governments, to name a few.

So, what can investors do to tide over market volatility? We bring you 4 strategies. 

A portfolio of high dividend yield stocks	Rupee cost averaging	Portfolio beta hedging	Long straddle/strangle option strategy
Carries relatively lower risk An equal weighted 10-stock portfolio comprising of PSU stocks like IOCL, Coal India, HPCL, BPCL, NMDC, Power Grid, NTPC and GSFC and private players Bajaj Auto and Infosys has a dividend yield of 6.4%  This portfolio has given a return of ~28% in the last one year versus 7% return of the Nifty 50	Spreads the cost of investments evenly over time, reducing risks associated with making substantial investments during unfavorable market peaks  The idea is to reduce the average price of the investment as one buys more during market downturn due to price correction Works best while investing at shorter frequencies like daily weekly and monthly compared to longer frequencies Rupee cost averaging on Nifty 50 has given a CAGR return of 14.26% compared to Nifty 50 CAGR return of 11.7% in the last 10 years	Proven strategy which protects the investor during volatile times The objective of this strategy is to reduce the riskiness of a portfolio by buying index put options or selling index call options. The risk is limited to the premium of the put option bought, which can be further reduced by using an effective stop loss The reward is minimizing loss during high volatility, leading to faster portfolio recovery.  If the portfolio beta is 1.3 and the portfolio value is Rs. 1 crore, the value of Nifty futures to be sold is Rs. 1.3 crore.   With 20,000 being the level at which hedging was required, the value of 1 lot of Nifty is Rs. 10 lakhs.  Hence a perfect hedge would be Rs. 1.3 crore/10 lakh, i.e., 13 lots of Nifty. We can either buy Nifty put options or sell call options.  From 20,000 levels, Nifty has corrected 5.5%, the portfolio would have corrected by 7.5%. The portfolio loss would be minimized to 4.1% if 19, 700 Nifty Put options were bought and to 5.3% if 20,300 Nifty calls were sold.	Historically, when implied volatility sustains below 10, there is a period of increased volatility in the near future. Long dated option strategies like long straddle and strangle can be created during such times as option prices are lower due to low implied volatility.  Long dated put option is purchased when the short term market outlook is uncertain.  This helps to protect the unrealized gains in the stock portfolio.  A long straddle is a combination of buying a call and buying a put option, both with the same strike price and expiration. For example, a long straddle strategy with a ATM strike price of Rs. 19,800 created on 10th of October for the November series is currently giving a ROI of ~12%.  A long strangle consists of one long call with a higher strike price and one long put with a lower strike. For example, a long strangle strategy with 19,500pe and 20,100ce created on 10th October for the November series is currently giving an ROI of ~16%.

 

So be game and use these strategies to leverage current volatility in the markets.

In conclusion, I would leave you with a quote from the Oracle of Omaha, Warren Buffet.

“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”