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Clocking In and Out: Trying to Time the Market? There May Be Ways

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March 16, 2017
Smashed clock: Better ways to time the market with cost averaging, options, and VIX
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Who says you can’t time the market? Actually, a lot of people, including experienced financial advisors.

“Timing the market is very difficult. An investor might get lucky once in a while, but to consistently be able to time the market is next to impossible,” said Robert Siuty, senior financial consultant for TD Ameritrade.

That said, there are ways traders and investors can use timing as part of their strategy. Just perhaps not in the traditional sense of trying to get into or out of a stock at just the right time.

Why Traditional Market Timing Often Fails

No matter what some of those investment ads might say, hardly anyone has the knowledge or luck to regularly determine when the market as a whole or an individual stock might bottom or top, and then get in just in time to take advantage—not to mention get out again before the stock moves the other way. One problem with traditional market timing strategies is that they often reflect prevailing market psychology, which is sometimes just plain wrong.

For instance, right before the presidential election, bullish sentiment stood at 23%, according to the American Association of Individual Investors. As we now know via hindsight, the markets were on the verge of a three-month rally that took stock indexes to record highs. So if less than one-quarter of investors were able to predict the timing of an historic rally, at least judging by that sentiment number, what does that say for the average investor’s ability to time the market?

If we could accurately time the market, most of us wouldn’t be reading (or writing) this article in the first place. We’d be enjoying an early retirement on the beach or ski slopes of our choice. The markets wouldn’t work for long if they were too predictable.

But all this doesn’t mean market timing isn’t sometimes valid way to trade and invest. Here are a few ways investors and traders can use timing as part of their investment strategy.

The Benefit of Cost Averaging

Imagine an investor wants to buy 1,000 shares of a $20 stock. The temptation might be to put all $20,000 in at once and make the money work. But that isn’t necessarily the only way, and there’s an alternate method that allows investors to potentially use time to their advantage.

“It’s more about cost averaging, not timing,” said JJ Kinahan, chief market strategist for TD Ameritrade. “What can hurt you is when you buy 1,000 shares at once, the market goes down, you sell it and then the stock goes higher.”

Rather than buy all 1,000 shares at once, Kinahan said, investors might want to consider purchasing smaller amounts of the stock at various prices as the market moves over days and weeks. That way, the investor might benefit through timing his or her trades, getting into the stock at various price points and potentially enjoying a smoother outcome. There’s no need to be predictive in this scenario; just consistent.

Let’s say an investor, instead of buying all 1,000 shares of the $20 stock at once, buys 200 shares at $20, another 200 shares when the stock falls to $18, another 200 shares when it falls to $16, and so on, taking some profit after the stock climbs above $20 again.

“You're using good logic making the trade,” Kinahan said. “You lowered your cost basis and enjoyed a nice run.” Taking some profit at various levels above the purchase price but keeping some of the money in the stock also allows the investor to let the trade work for them.

And even if the stock then dives and goes back down to $16 or $18, the investor, having bought it at prices as low as $16, wouldn’t lose as much money as if they bought it all at $20. The investor has lowered the average cost basis, and this new price may offer a buying opportunity 

“People sometimes see price volatility as an enemy, but you can make movement your friend,” Kinahan said.

That said, a dollar cost-averaging strategy will incur additional transaction costs, which can impact any potential returns.

Explore Your Options

Another way to use timing is to take advantage of the options market if your account is approved for options trading.

“Using options allows you to get down to an exact week in timing a trade,” Kinahan said. "Rather than buying just a single option, you might consider buying or selling call spreads or put spreads. Define your risk up front, and target the time frame that might fit your needs.”

Remember that transaction costs (commissions and other fees) are important factors and should be considered when evaluating any options trading. Multiple leg options strategies and dollar-cost averaging strategies can generate significant transaction costs, including multiple commissions which will impact any potential returns. 

Use VIX to Help Choose Sectors

Keeping an eye on the CBOE Volatility Index (VIX) can also help investors who want to use market timing as part of their strategy. VIX tends to climb during times of market distress and turmoil, for instance in late 2008, when stocks collapsed and VIX rose above 50 (the historic average is under 20).

Today, in contrast, VIX is extremely low (below 12 as of mid-March) and stock values have been on the rise.

An investor who tried to time the market traditionally during these scenarios might fail, but one who used VIX as a road map to certain sectors might find themselves in a better position, said David Settle, curriculum development manager for Investools.

“It’s all about return expectations,” Settle said. “Right now, VIX is low and stock values are very high. How would you trade? You’d consider positioning your portfolio into more stable stuff. If the market goes up, those stocks might, as well, but you’re not expecting double-digit returns in the next week.”

And when VIX is high and stock values are low, Settle added, investors could consider getting into more volatile and growth-driven sectors such as tech and financials, because return expectations could be higher. “You might consider high-momentum companies when things are beaten up,” he said.

Keep Long-Term Objectives in Mind

Before considering any sort of timing strategy, even the more nuanced ones mentioned by Kinahan and Settle, it’s important for investors to go over their long-term objectives. For long-term investors, more complex trading strategies that take advantage of timing may be less necessary. The market has tended to move higher over the decades, despite hiccups here and there, history shows.

“A better course of action may be to look at pullbacks or corrections as potential opportunities, especially if you have a long-term time horizon, by staying the course and being disciplined,” Siuty said. “Making systematic, periodic additions to your diversified portfolio over time and taking advantage of things like dollar cost averaging can bode well for building wealth in the long run.” 

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