Trading Volatility through Uncertainty

In most cases, it makes sense to hold and own the S&P 500 index for as long as possible. Anytime someone asks Warren Buffett for investment advice, he recommends the S&P 500 index for two specific reasons. The first is because the S&P 500 index has a 100-year track record of compounding capital at 7-8% annually. The compounding is consistent but returns can be volatile because of the market cycles. The second reason is to own the S&P 500 index is because of the low-cost fee structure provided by ETFs. The expense ratio for investing any S&P 500 index ETF is a tenth of a percent. It is super cheap because it is very competitive across issuers like Vanguard, Blackrock and State Street.

Now buying the S&P 500 index makes sense for most investors. Preferably you want to dollar-cost average into the index, which means buying during the highs and lows. This means automating your investment process over time. However the problem most investors face is that volatility entices fear and greed. And chances are, you know exactly what I’m talking about.

Fear Drives Market Returns

In the past week, the market has sold off almost +10% across the globe. President Trump’s plan to rollout reciprocal tariffs was not well received by investors in the first few days last week. However you can see that after three days, the market losses were reversed for a brief moment on April 8th.

But you can see that these returns are short-term and short-lived. Smart money came back into the market and chose to sell off stocks again. This was on the cusp of the Administration raising tariffs on Chinese exports to 104% at midnight tonight. President Trump will be providing more tariff updates on April 9th, but until then fear has taken over the market.

Before we dive into market volatility, I want to zoom out for a minute. It’s important to see that even if the market declined by +10% for the past week, the S&P 500 index is only down 4.22% for the past year. In fact, if you invested in the S&P 500 five years ago in 2020, you would be up 78.61%, which is an amazing return for the average investor. It was only from 2022 to 2024 when the market returns were pretty much flat.

If you are not a professional trader, investors tend to get in trouble when the market introduces volatility. No one likes to see losses in their portfolio so the natural next step is to sell stocks or buy stocks. Either way you are attempting to trade the market. Volatility is invoking an emotion which is resulting in a new action. If you don’t have preset investment guidelines, then you are risking a lot of investment capital.

The Market is Trading for You

When returns become volatile, you might be interested in capturing 2-3% on a specific trade. It’s very possible to do when there is uncertainty in the market. However it’s also possible to lose 2-3% if you don’t know how to trade. That’s why many money managers will hedge client portfolios by buying puts or buying volatility (VIX). That’s why we call them hedge funds.

Buying futures, options and derivatives are common ways to increase returns during a down market. However the problem comes from timing the market. The main problem with buying volatility instruments like options is that they have time decay and leverage built-in. Which means if you bet on the wrong direction, your principal investment will erode very quickly.

Now if you have been following the markets for the past week, you might have heard about the VIX, or the volatility index. It tracks the 30-day forward-looking volatility, and is derived from S&P 500 index options prices. It gives us good insight on whether investors are buying or selling in real-time. In fact, the VIX is famously called the ‘fear index’ by many on the Street.

If you don’t trade options, then it is important to learn the details of volatility. But you can monitor the VIX to understand what professional options traders are doing in real-time. In this particular case, investors are hedging their portfolio and expecting more market volatility. Which is why the VIX skyrocketed for the past five days.

But since trading is a short-term phenomenon, the VIX pricing will probably collapse over the next 30 days. Remember, the VIX is a derivative of the underlying security, which is the S&P 500 index in this circumstance.

At the moment, investors can anticipate more volatility as we’ve seen today. But without certainty, it’s tough to predict where the market will go over the next 30 days. For example, if we enter a serious trade war or something goes south, volatility will go much higher, much sooner. If you want to trade specific stocks, it’s worth monitoring the VIX to better understand what the market is doing. If it is spiking, chances are there are a lot of unknown unknowns that haven’t been priced in yet. If the VIX is flat, then you might be dollar-cost averaging at a good moment in time.