How to ride an up-and-down market

chart_ws_stock_ipathsp500vixshort-termfuturesetn.top.png By Adam Lashinsky, senior editor at large


FORTUNE -- Volatility in the stock market is a lot like turbulence on an airplane: scary, nausea-inducing, and, if at all possible, best to ignore. Just as a plane almost certainly will land safely despite the uncomfortable bumps, the market usually rises over time (the gruesome past decade notwithstanding). Yet while for the vast majority of investors the sensible thing to do in the face of choppy markets is nothing at all, some yearn to seize the day. After all, seesawing prices can mean opportunity.

By that measure there has been plenty of opportunity of late. The Dow Jones industrial average (INDU) registered triple-digit gains or declines 22 times between April 20 and June 9, the most since the financial crisis of late 2008. Here, then, are three approaches to volatility that anyone can take -- provided you have the stomach and the attention span to do so.

"Rent" your stocks

One way to profit in unstable markets is to sell call options on shares you already own, a strategy that Jon Najarian of online brokerage TradeMonster.com likens to earning extra cash by "renting out" your stocks. (Such options, sold through brokerages such as Schwab, are available only on the most widely traded stocks.) Selling a call option means you collect a fee for granting another investor the right to buy your shares at an agreed-upon price. That's a particularly lucrative approach right now, Najarian says. Volatility has spurred increased demand for call options, sending their prices up 20% in recent months.

For example, imagine you own 100 shares of McDonald's (MCD, Fortune 500) stock, which was trading at $69 in early June. At that price, you're already receiving a 3.2% annual dividend; Najarian says you can earn an additional 1.7% return per month by selling the call options. Here's how it works: Let's assume you think fair value for the stock is $70. So you sell call options at $70. If the stock stays below that level, you'll collect $120 per month in fees as long as the contract runs (typically a month) and can hold it as long as you like. The potential hitch: If McDonald's shares jump, say, to $75, the buyer can purchase your shares at $70 and you give up some of the gain.

Bet on volatility itself

Stock market turbulence has a gauge colloquially known as the "fear index" and often referred to by its ticker, the VIX (more properly, it's the Chicago Board Options Exchange Volatility Index). The VIX comprises a variety of options contracts that reflect how much options investors believe the S&P 500 stock index (SPX) will move -- either up or down -- in the next 30 days.

Investors can buy an exchange-traded note (similar to an exchange-traded fund) that aims to make money off moves in the VIX. The iPath S&P 500 VIX short-term futures ETN (VXX) mirrors the VIX and rises when options investors take out the most insurance against a falling stock market. Tom Lydon, a wealth adviser in Newport Beach, Calif., and publisher of the website ETF Trends, recommends a specific strategy for playing it. "If it's above its 50-day moving average, you buy," he says, because the trend favors increased volatility. "If it falls below the 50-day moving average, you sell."

Making such a bet on volatility, it should be emphasized, is antithetical to a buy-and-hold philosophy and should be used with extreme caution. For starters, a volatility investor has to monitor the position constantly. For roughly a year before this spring, volatility was tame, and VXX got hammered, losing more than 50% of its value as the stock market smoothly soared (see chart at top of page). Moreover, VXX uses borrowed money to juice its bets, so it swings even more wildly than the market. On the day in late May that Lydon shared his strategy, the S&P was experiencing a moment of euphoria, up nearly 3% for the day. VXX, by contrast, was off 8%.

Lydon suggests staking no more than 3% to 5% of your investable assets on such a gambit. In an unstable market a small volatility position will help make up for losses elsewhere; in a placid market the money lost will be an acceptable hedge.

Stay the course

Even if you don't try to exploit volatility, at minimum you shouldn't run from it. "In general, when the public gets scared, that's the time to take advantage of volatility if you've got the intestinal fortitude," says Najarian. "At the very least it's a signal to not get out of the market, because investors inevitably bail out at the bottom."

Put differently, one response to volatility is a non-response: not so much ignoring it but acknowledging that today's big move is transient and realizing the truism that your long-term investments will pay off (if done prudently) -- in the long term. Indeed, chaotic markets provide a strong rationale for that venerable staple of investing wisdom: dollar-cost averaging. If you regularly contribute to, say, a 401(k) that buys a few shares of an index fund every two weeks, you may find yourself occasionally buying on an upward spike, but you are almost equally guaranteed to benefit from the downswings too.

Air passengers are sometimes mystified at the calmness of pilots during a rough flight. But professionals have a better sense of what's worth being afraid of. Regular investors may never achieve that steely calm. There's no reason, however, they can't learn to tolerate, if not enjoy, the ride.

--Reporter associate Doris Burke contributed to this article. To top of page

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