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).

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