In the “flash crash” on May 6, 2010, the Dow Jones Industrial Average dropped nearly 1,000 points only to recover more than 600 points by the market close. On the heels of the financial crisis of 2008, this incident only exacerbated investors’ concerns. Some strategies to manage volatility risk that CPAs can recommend to clients are:
Diversify. Overall risk can be reduced by investing in a variety of assets and asset classes, not just stocks.
Refrain from market timing. Individual investors who maintained a long-term, diversified investment strategy and did not sell at market lows in 2009 have recovered a large portion of their paper losses. Those who sold at market lows only to buy back into the market as the market rose committed a classic investment mistake.
Only use limit orders. A limit order is an order to trade at a specified or better price. In contrast, a market order is an offer to trade at whatever the market price happens to be when the trade is executed. During the flash crash, trades ranged from $0.01 to $100,000 (although certain trades were later canceled).
Never use stop-loss orders. A stop-loss order becomes a market order when a security trades at or below the order price. Use of stop-loss orders means a position could be liquidated at potentially very low prices during periods of extreme volatility.
Avoid excessive use of exchange-traded funds (ETFs). By design, ETFs are diverse investment vehicles that trade throughout the day like common stock. While ETFs can be an effective tool for certain investors, their short-term price risks are typically not recognized by many individual investors. During the flash crash, many less liquid ETFs experienced large price aberrations. ETFs represented a staggering 70% of all trades canceled on May 6, 2010.
Avoid margin. The use of margin (money borrowed from a broker with investments as collateral) can be very risky in volatile markets. The use of excessive margin can force sales when markets suffer an intraday minicrash such as the flash crash.
Refrain from writing puts or uncovered calls. In exchange for upfront premiums, the seller of a put option must purchase a stock at a specified price, and the seller of a call option is obligated to sell a stock at a specified price. Writing puts and calls can be extremely risky. Use of uncovered calls is a fundamental mistake (an uncovered call obligates the seller to sell stock not owned at a set price, in essence creating unlimited liability). Although writing covered calls and buying puts can be a risk-reduction strategy, it is costly in terms of forgoing upside appreciation potential above a call’s strike price.
Unless investors are satisfied with the returns of strictly short-term (and low-yield) U.S. Treasury securities, some degree of market exposure and risk is necessary to earn a return. Investors who simply held on to their positions during the flash crash had recovered all or most of their paper losses within about a week. While future market directions are unknown, individual investors who did not panic or were not forced to sell during this latest market instability were in positions to re-evaluate their investment strategies at little or no cost.
By Luis Betancourt, CPA, Ph.D., William M. VanDenburgh, Ph.D. and Philip J. Harmelink, CPA, Ph.D.
Article Source: Journal of Accountancy