Trading 2012: Reacting to volatility

With uncertainty seemingly everywhere, traders may want to prepare for continued volatility.

2011 may be remembered by many investors for two things: volatility and correlations. Day after day, it seemed like the markets were posting hundred point gains or losses, and, when the market moved, it seemed like everything moved together.

For some stock pickers and long-term investors, it was a stomach-turning experience, but for traders, it may have been more of a rodeo—the ride had plenty of bumps, with opportunities for glory or injury.

So what will 2012 hold? To help active traders and investors plan for 2012, we asked a collection of pros to share their insights into the financial trends, products, and strategies that will shape trading in the coming year. Please note that the following material represents solely the opinions of those professionals and not necessarily those of Fidelity Investments.

Strategies to handle volatility

Volatility levels were near the top of the charts in 2011. In fact, the New York Times reported that excess market volatility rose to levels seen only three times in the preceding 60 years. Faced with continued uncertainty about the eurozone crisis, U.S. unemployment and fiscal policy, and even economic growth in China, Loren Fox, senior research analyst at Strategic Insight, says that traders might have more volatility to look forward to in 2012. According to Fox, “Volatility will continue to be not just cyclical but a longer-lasting trend. 2012 will also be a big election year, and that won’t help: it will generate more headlines that will spark reactions from investors and traders.”

Because of the volatility, many people will be looking for alternative investment strategies in mutual fund or exchange-traded fund (ETF) form. “I think we may continue to see an increased appetite for alternative mutual funds that manage or reduce volatility,” Fox says. “An increasing number of funds are falling outside the traditional, nine style box model. While alternative funds are still a small part of the market, they are not a fad du jour.”

Go anywhere. One option catching the eye of investors—go anywhere funds that are free to invest in any asset class anywhere in the world. As opposed to conventional funds that may simply try to provide beat a benchmark for a given asset class or investment style, many of these funds aim for absolute return. Funds that seeks absolute returns focus on producing positive returns regardless of the market conditions—employing strategies such as.long and short positions, derivatives, futures, options and other less conventional strategies. These investment strategies introduce additional risk and can magnify any losses.

“A record number of these hedge fund-like products have been launched in recent years, and dozens more are in the pipeline to launch,” Fox says. “Some investors have been shying away from traditional U.S. stock funds, but these nontraditional funds have been selling very well,” he adds. “I think this is a trend that will continue in 2012.”

Go global. Another trend that may continue into 2012 is investor appetite for funds that offer global exposure. With investors looking to tap into faster-growing economies, and attempting to navigate an increasingly integrated global economy, funds that can go to any part of the world have become more attractive. “We have seen increased demand for emerging-markets funds and also for global tactical asset allocation (GTAA) funds,” says Fox. “These GTAA funds, which invest in multiple asset classes in any geography, vary widely in their approach, but they all offer the promise of more nimble management of funds in a volatile market environment.”

The problem, Fox says, is that some of these products are hard to define, and can be confusing to some investors. “The challenge with all these funds is that they are more complex and require more work for investors to understand how they work,” Fox says.

Alternative ETF strategies

The risks of leveraged ETFs

The risks of leveraged ETFsLeveraged and inverse exchange traded products are not designed for buy and hold Investors or investors who do not intend to manage their investment on a daily basis. These products require a Most Aggressive investment objective and an executed Designated Investments Agreement to purchase. These products are for sophisticated investors who understand their risks (including the effect of daily compounding of leveraged investment results), and who intend to actively monitor and manage their investments on a daily basis.

From January through December, the ETF industry added more than 300 new products, according to ETF Database, bringing the total number of offerings above 1,400. Traders were given complex choices for everything from VIX-based ETFs to target-date high-yield bonds funds. In 2012, expect that even more ETFs will be launched.

For buy-and-hold strategies, some investors have been looking to income-oriented stock products, though past performance does not guarantee future results. “Some higher dividend-paying ETFs have done well,” says Paul Justice, director of North American ETF research at Morningstar, “and if the market turns downward, you might still get a return north of one percent. These ETFs are low-cost, tax-efficient products that can deliver satisfactory results as long as you know how to execute your trades effectively and keep portfolio turnover low.”

Some very aggressive and sophisticated traders have turned to inverse funds, as an alternative to shorting a stock. “You won’t get a margin call with an inverse fund, and your losses can’t go to infinity like with shorting stocks,” Justice explains.

On the other hand, Justice suggests using caution when considering these ETFs, particularly highly-leveraged ETFs: “They are very speculative tools that are traded on a one-day basis.” This is especially important because inverse and leveraged ETFs can have performance that is very different from the index they attempt to replicate over time, because of tracking error and the complexities of shorting strategies.

Option strategies for managing volatility

Option expert Bill Luby says: “The things that caused volatility to spike in 2011 haven’t gone away.” Option traders will need to be aware of the European debt crisis, the U.S. debt ceiling, Iran, North Korea, and the tug-of-war of inflation vs. growth in China as they watch to see how volatility will affect premiums and the market.

“In 2012,” Luby says, “February, March, and April could be the big three months. That is when Italy will have to refinance a huge portion of the sovereign debt that is coming due. If their debt problems aren’t solved by April, everything will hit the fan. I think we’ll know by the end of the first quarter what happens.”

Luby says that, for speculators, more volatility means more opportunity. Option traders who want to speculate on higher volatility, may want to consider strategies such as long straddles, long strangles, short condor, and short butterflies.(Options trading at Fidelity requires an agreement and prior approval).

There are lots of choices for investors looking to protect themselves from volatility as well. “If you want to hedge yourself against volatility, you can buy out-of-the-money VIX calls, which are excellent disaster insurance or protection,” says Luby.” Luby also mentions selling covered calls if we have a sideways market, although in a bull market your gains are limited.

The transaction tax: Could it pass?

Another looming 2012 issue for traders is the transaction tax, a proposed fee that could be added to every stock and bond transaction. This tax has alarmed many in the financial services industry. “A 0.03 percent tax or fee on every trade sounds tiny,” warns CPA Robert A. Green, CEO of GreenTraderTax.com. “But if you trade a lot, it will add up. For some investors, the tax might cost them thousands of dollars, but the tax will put active traders and high-frequency traders out of business. Although the tax is aimed at penalizing Wall Street, it ends up hurting retail traders.”

Although the transaction tax is unlikely to pass in the United States, Germany and France are pushing for it. “If it’s passed in Europe,” says Green, “it will have worldwide ramifications. It would be a market-shocking event, and could snowball to other countries.”

End-of-year tax strategies

Fortunately, few tax regulations will be passed until after the November elections. “Because tax rates won’t go up until 2013, traders and investors can accelerate their business deductions, accelerate their itemized deductions, and do regular wash-sale and tax planning,” Green says.

Green suggests that you take the time to brush up on basic tax laws in 2012. “Most business traders don’t know that they can elect Section 475 mark-to-market accounting for ordinary loss treatment on their securities trades,” he says. “As a result, some traders may end up paying more money than they should. Business traders can also deduct all their business losses and expenses and avoid self-employment taxes.” Another misconception is the wash-sale rule and how it may be handled by those who qualify as having an active trading business. “Sometimes wash sales can be helpful and better than a capital loss carryover,” Green explains. “They can be converted to an ordinary loss next year with a Section 475 mark-to-market election.” Keep in mind that a Section 475 mark-to-market election has other consequences to consider.

Focus on your goals and risk tolerance

No matter what happens in 2012, you should not be distracted by headlines, but focus on your long-term and short-term goals. “It’s a challenging time to be an investor, but it always is,” Fox says. “You don’t know whether you’ve been through a bull market until the end, nor a bear market until all your investments are down.”

In 2012, more people will be focused on assessing their risk tolerance. Before, investors assumed that higher risk equaled higher reward. “Now, people realize that investing in the market is risky, and it is,” says Justice. “So you have to address how tolerant you are of those risks, and how long you can wait until the invested money is needed elsewhere.”

Michael Sincere is the author of Understanding Options (McGraw-Hill, 2006), Understanding Stocks (McGraw-Hill, 2003), and All About Market Indicators (McGraw-Hill, 2010).

10 ways to trade penny stocks

MIAMI, Fla. (MarketWatch) — The allure of penny stocks is simple: They don’t cost much money and promise big profits. But trading penny stocks is also a good way to lose money.

Sure, it’s possible to profit when you understand the game, but the odds are against you when you don’t. And worse: manipulators and scammers often run the penny-stock game.

For investors who can’t afford shares of Google or Apple, the potential gains from trades like this are too good to pass up. So penny-stock trading thrives. With a relatively small investment you can make a nice return if — and this is a big if — the trade works out. For example, say you buy 10,000 shares of a $.30 stock for $3,000. If the stock reaches $1, you’ve made $7,000, doubling your money. Read more: 5 strategies if you have less than $3,000 to invest. 

Dollars and sense

Penny stock promoters make sure to attach a disclaimer to their email, Twitter, or Facebook page, and take advantage of this language to embellish and deceive.

Penny stocks and their promoters also tend to stay one step ahead of securities regulators, though just last month the Securities and Exchange Commission charged a Florida-based firm, First Resource Group LLC, with penny-stock manipulation. Read more: Simple rule: Don’t buy a penny stock.

Even with these clear dangers, some people insist on trading the pennies. So, if you find yourself on the receiving end of a telephone call from a penny-stock promoter, or you spot an advertisement that promises dollars from your pennies — and you still decide that maybe penny stocks aren’t wooden nickels, just remember these 10 rules:

1. Ignore penny-stock success stories

Timothy Sykes, a penny-stock expert who trades both long and short, says you must not believe the penny-stock stories that are touted in emails and on social media websites.

“You have to say no,” Sykes said. “You can’t invest in penny stocks as if they were lotto tickets, but unfortunately that’s what most people do, and they lose again and again. Think of penny stocks as inmates in a prison that you can’t trust.”

Instead, Sykes says, focus on the profitable penny stocks with solid earnings growth and which are making 52-week highs.

2. Disregard tips and read the disclaimers

Penny stocks are sold more than bought — mostly via tips that come your way in emails and newsletters.

“The free penny-stock newsletters are not giving you tips out of the goodness of their heart,” Sykes said. “If you read the disclaimers at the bottom of the newsletters, they are getting paid to pitch a stock because their investors want exposure for the company. There is nothing wrong with wanting exposure, but almost all penny newsletters make false promises about their crappy companies.”

Sykes says there is a difference between stocks making a 52-week high based on an earnings breakout and stocks making a 52-week high because three newsletters picked it. Reading the disclaimers at the bottom of the email or newsletter, which the SEC requires them to do, will usually reveal a conflict of interest.

“Most newsletters don’t tell you the truth,” Sykes said. “They are being compensated to pump up the stock, and they rarely tell you when to sell. Often it’s far too late.”

3. Sell quickly

One allure of penny stocks is you can make 20% or 30% in a few days. If you make that kind of return with a penny stock, sell quickly.

Unfortunately, many traders get greedy, aiming for a 1,000% return. Considering that the penny stock you’re in might be getting pumped up, take any profits and move on.

4. Never listen to company management

In the murky penny-stock world, don’t believe what you hear from companies.

“You can’t trust anyone,” Sykes said. “The companies are trying to get their stock up so they can raise money and stay in business. There is no reliable business model or accurate data, so most penny stocks are scams that are created to enrich insiders.”

Sykes says large rings of the same people run promotions using different press releases and companies, including the reappearance of a notorious stock manipulator who was first convicted for an email pump-and-dump scheme when he was in high school.

5. Don’t sell short

Although shorting pumped-up penny stocks may seem attractive, don’t do it.

Penny stocks are too volatile, and if you’re on the wrong side of the trade, you could easily lose 50% or more on a short squeeze. Another problem is that it’s difficult to find shares of penny stock to short, especially those that made huge moves based on hype and newsletter tips. Leave shorting penny stocks to the pros.

6. Focus only on penny stocks with high volume

Stick with stocks that trade at least 100,000 shares a day. If you trade stocks with low volume, it could be difficult to get out of your position.

“You must be aware of the number of shares traded and the dollar volume,” Sykes said. He also suggests that you trade penny stocks that are priced at more than 50 cents a share. “Stocks that are trading less than 100,000 shares a day and are under 50 cents a share are not liquid enough to be in play,” he added.

7. Use mental stops

Because the bid-ask spreads on many penny stocks can be high, as much as 10%, hard stop-losses can actually cause you to lose money. p>

Although it takes more concentration, use mental stops. “I focus more on risk-reward than stops,” Sykes said. “If I want to make a dollar a share on a three-dollar stock, I will cut my losses at 20 cents so I have a 5:1 risk reward. I aim for 3:1 or 4:1, but not 1:1 or 2:1. If I think a dollar stock has only 50-cents upside (2:1), my mental stop loss will be at 10 cents because the risk-reward is better.”

8. Buy the best of the bunch

Sykes looks to buy penny stocks that have had an earnings breakout.

“I love buying penny stocks when they have good earnings, or when they are breaking out to 52-week highs on volume that is at least a quarter million shares a day,” he said. “They are easy to find if you look.”

The challenge is to find stocks that make 52-week highs that aren’t due to a pump-and-dump scheme. Examples of penny stocks that have fit Syke’s criteria in the past include Tangoe, Magal Security Systems, and Staar Surgical Co.

9. Don’t trade large positions

“You really need to be careful with position sizing,” Sykes said. “I learned the hard way not to trade big. My rule now is not to trade more than 10% of the stock’s daily volume.”

In addition, he said, limit your share size so you can get out of the stock faster.

10. Don’t fall in love with a stock

Every penny stock company wants you think it has an exciting story that will revolutionize the world. If you enter the penny stock arena, be cynical, do your own research, and diversify, even if a friends or family member is touting a stock.

Penny stocks have earned their bad reputation, so beware.

Michael Sincere is the author of Start Day Trading Now (Adams Media)

Penny Stock Pros and Cons

I wrote an article about the pros and cons of penny stocks for Marketwatch, which you can find here: http://bit.ly/wl7S1r

My article is one of the most popular today. In my article, I didn’t include the following information: The penny stock that is being touted by newsletters and on email is NSRS (North Springs Resource Company). Although this dollar stock is on a roll right now, the good times will eventually end. After being up as much as 25% a day on some days, if you made any profits on this penny stock, take the money and run.