InvestorQ : Can you tell me how to frame my stock selection strategy at a time when the markets are extremely volatile as is the case now?
Anu Biswas made post

Can you tell me how to frame my stock selection strategy at a time when the markets are extremely volatile as is the case now?

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Neelam Naik answered.
7 months ago

We recently saw a harsh post budget sell off and then an equally powerful recovery. This is part and parcel of market gyrations when the indices are at these levels. It is not just about market cap. The volatility also went up sharply during this period. Normally, when the markets become volatile it is accompanied by a rise in the VIX ratio. That can be a double edged sword as it can have a cascading effect. The question is what should be your investment strategy in this kind of market volatility? Here is how you go about it.

Watch out for value stocks that have corrected

Most volatile corrections tend to overdo on the downside. That was the case as many quality large cap stocks in India lost close to 50-60%. Of course, in cases like steel, oil extractors and PSU banks, the correction has been much sharper over the last one year. What the January correction has done is to bring many quality stocks with strong earnings visibility into more reasonable levels. These are the companies that investors need to focus on. We would suggest a phased approach with respect to such stocks. An impetuous lump-sum investment never makes sense in a volatile market. The volatility will give intermittent dips and use these dips to accumulate quality stocks at decent prices.

Normally, you see lustre return to mid cap stocks in such times

We suggest mid caps for a variety of reasons. Firstly, they are not as susceptible to the typical macro issues like weak oil prices, falling commodity prices, China slowdown and weakness in the capital cycle. In fact, these mid cap companies are the biggest beneficiaries of the sharp fall in oil and other commodities. Secondly, if one looks at the Q3 numbers, over 50% of the mid cap companies have announced EPS growth that is faster than their 5-year average. That gives the added advantage of earnings visibility. Thirdly, after outperforming large caps in year 2015, they have underperformed in the month of January 2016. This offers an attractive price point to enter these stocks. Look out for mid-cap stocks with robust business models, high ROE and who have managed to hold prices in a falling market. These will be the mid-cap stocks to focus on.

You must broaden your horizon and look at assets other than equity

As an investor, equity is one of the asset classes that you have an option to buy. Look at other asset classes too seriously. For example, the RBI has taken a dovish stance in this policy that has kept the window open for further rate cuts. That will typically be positive for long term bond funds with exposure to government debt and corporate bonds. Try to diversify some of your investment into such debt funds so that you get the triple benefit of safety, security as well as capital appreciation when rates come down.

Gold is another asset class that serious investors need to look at. Gold can be bought in a variety of ways. The government regularly announces gold bonds where one can hold this precious metal in non-physical form. You not only get the benefit of safety and convenience but also participate in price appreciation of gold. Remember, historically when there is global uncertainty and geopolitical risk in world markets, gold has outperformed other asset classes. You can also buy gold ETFs where your asset value will appreciate with the international price of gold. This is surely an investment option for you to consider seriously.

How should to plan your strategy in volatile times and stay ahead of the curve?

Do volatile markets have anything for traders? Actually, a lot! When the VIX is high, it gives a great opportunity for traders to participate in the volatility without taking a directional view. Normally, such volatile strategies do not work when the markets are in a range or when the VIX is below 15. In such cases your options will expire worthless and the risk-reward will be negative for you. So how can traders make the best of volatile times?

Straddles and strangles are a great way of participating in these volatile markets. Since markets are volatile, you gain on price as well as on time value. That gives you twice the chance to be profitable on a volatile strategy. Most frontline stocks are at the cusp of a breakout and any movement will give you ample opportunity to benefit from volatility. The sharp movements will give you sufficient room to cover your cost of call and put. This can work only as long as the volatility in the market remains high and the traders can make the best of it. Of course, there are two lines of caution here. Try to play with a stop loss, which should be based on volatility rather than on price. If VIX falls below a certain level, just exit your position. Secondly, do not go too much out-of-the-money and keep your strikes as close as possible. Volatility gives its own set of opportunities. The ball is in your court how to make the best of it.