By Adinah Brown

On January 15th, 2015, when the SNB suddenly decoupled the Euro from the Swiss Franc, perhaps unbeknownst to the SNB at the time, they released a torrential avalanche, where traders all over the world lost millions of dollars in a matter of moments. The EUR/CHF crash forced numerous forex brokers into insolvency in their inability to cover their client’s positions and stop losses were unable to catch the momentous fall causing devastating slippage. Within minutes trillions of dollars were wiped out of the financial markets, with little resources for the traders to call on, once the proverbial shit hit the global-market-fan. With incidents like these at the forefront of our mind, we consider a range of risk management techniques that would be effective at times of high volatility such as the infamous Black Swan event.

One of the most common techniques is the application of modern portfolio theory (MPT) where diversification is used to create groups of assets that are able to withstand volatility. This technique applies statistical measures to determine an efficient frontier for an expected amount of return in relation to a defined level of risk. Applying this theory involves examining the correlations between different assets and determining the volatility of those assets in order to create an optimum and well balanced portfolio. In the Black Swan event, financial institutions such as Alpari UK, were not applying the MPT theory to sufficiently manage their risk, undoubtedly causing their insolvency as a result of the plummeting value of the EUR/CHF.

Options are another valuable tool to manage risk during volatile periods. An investor who wishes to hedge a particular stock with reasonable liquidity can buy a put option to protect themselves against the risk of a downward movement. The option gains value as the price of the underlying security drops. However, the drawback to using an option is that its price will often go at a premium. Furthermore, an option is also subject to time decay as it loses value as time encroaches upon its expiry date. This strategy although effective, will only protect the individual stock that it’s being hedged against, an investor with diversified holdings will not be able to afford covering each of his positions with an option put.

Investors who want to hedge a larger portfolio of stocks should use index options. These broad based indexes track larger stock indexes such as the S&P 500 and Nasdaq which cut across many sectors and therefore their movements represent a good reflection of the overall economy. Historic charts have shown that stocks tend to be correlated, meaning that they generally move in the same direction, especially during periods of high volatility. By using index options an investor can hedge a diversified portfolio of stocks and hedge indexes with put options to minimize risk. Although doing this in a dooming period of volatility can also be expensive, at least this strategy provides protection across an entire portfolio.

Lastly, there is also the possibility to hedge using the volatility index indicator (VIX). This strategy measures the implied volatility of “at the money calls” and puts that are currently on the S&P500 index. Otherwise known as “the fear gauge”, it rises during periods where there is a lot of volatility. As a guide, a level below 20, indicates that the market is in low volatility, while a level above 30 indicates a highly volatile market. Investors also make use of exchange traded funds (ETFs) to track the VIX, ETF shares or options can go long on the VIX explicitly for the purpose of being used as a volatility specific hedge.

About the Author:

Adinah Brown is a professional writer who has worked in a wide range of industry settings, including corporate industry, government and non-government organizations. Within many of these positions, Adinah has provided skilled marketing and advertising services and is currently the Content Manager at Leverate.