Living With Volatility

While market volatility can be nerve-racking, including certain investing strategies can help soften the blow or allow you to generate significant upside from these big swings.

For more conservative investors, diversifying into alternative asset classes is a good way to remain fully invested while not fully exposing yourself to just the stock and bond markets.

“Many alternative asset classes have very low correlations to stocks and bonds,” says Edward Egilinsky, managing director of Alternative Investments at Rydex Investments.

“Historically when you blend in alternative investments, they have been shown to reduce risk and improve the rate of return,” he said.

Commodities & ETFs

While adding alternative investments -  such as commodities, currencies and real estate -- may not be appropriate for investors seeking an income stream, Egilinsky said those looking for capital appreciation would be wise to have a 10% to 15% allocation to alternative investments.

Another strategy that can allow investors to lessen the risks associated with individual stocks is to purchase exchange-traded funds, or ETFs, instead of individual stocks. For instance, if you believe the energy sector is going to do well, instead of buying shares of a particular energy company, whose stock can be impacted by a myriad of company-specific factors, you could purchase an ETF that represents the overall energy sectors.

By buying the ETF you are getting exposure to many different companies in the sector and are less likely to be majorly impacted if one of the companies experiences a dramatic drop in value.

ETFs are also useful tools for pair’s trades, which is a strategy that entails matching two securities – one that you expect will rise and one that you expect to fall. For instance, if you expect shares of a technology company to rise but your overall view on the sector is negative you can buy shares of the individual stock and then pair that with a short position in an ETF that represents the sector.

Open To Options

There are also strategies that can be used by more sophisticated investors in order to take advantage of the volatility to boost returns. High on this list is hedging and in particular, the use of options.

“There is a lot of opportunity to capture fairly significant returns through the utilization of options,” says Howard Rosencrans, chief research analyst with Value Advisory LLC.

The attraction of options has grown with the proliferation of inexpensive online trading platforms. OptionsXpress , founded in 2000, TradeStation Group , E*Trade   and INVESTools’ unit thinkorswim all allow retail investors to trade options, as they would stocks.

Buying stock options allows you to buy or sell shares of a security at a certain price over a certain period of time. Buying a put option allows you to sell shares of stock (options contracts are for 100-share lots) to the writer or seller of the put at a specified price. To do this you have to pay the writer a premium, which is the difference between the current price and the agreed upon (strike) price for each share. Buying call options, meanwhile gives you the right to buy shares from the call writer at a certain price within a certain period of time, again in return for paying a premium to buy the call options.

Rosencrans believes that writing puts and calls can act as a good strategy in the current market.

“Options premiums are huge,” Rosencrans said adding that if you write a put, the theoretical worst-case scenario is that you it lets you liken to the ownership of the stock at a lower price while writing a call allows you to collect a significant premium.

“With puts, as long as you want to own the stock it’s attractive,” he says. And when it comes to writing calls, he adds it "creates income or protection. If the call is not exercised against you the premium you collect reduces your cost basis.”

Todd Salamone, senior vice president of research with Schaeffer's Investment Research, agrees that using options can be very advantageous to investors.

Say you like a stock that has had a good run and is trading at $120 a share. You could buy a call that allows you to buy the stock at $100 in May. Since one contract equals 100 shares you will have to pay $2,000, compared with $12,000 if you were to buy 100 shares outright at the current price.

“You get exposure to a volatile stock with significant less cash outlay,” says Salamone..

If the stock moves to $140 a share, that $2,000 investment is now worth significantly more. Meanwhile, if the stock tumbles you have limited dollar risk.

“Because of call and put options you can make money in up or down markets,” says Salamone. “We think within the scope of the volatile market it is good to have exposure on both  the put and call side…The most you can loose is what you invest but you can make multiple times what you put up.”

Short Vs. Long

Another strategy is the use of inverse and leverage ETFs or mutual funds. Inverse, also known as short products let you profit when the market falls. For example, the Rydex Inverse 2X S&P 500 ETF    aims to provide results equal to twice, or 200%, of the inverse performance of the S&P 500 on a daily basis (minus fees and expenses).  So if the S&P 500 index falls 1% the ETF will rise 2%.

On the other hand, if you want to make a bet that the market is going to rise you can use leveraged funds, which let you make larger bets on the market. The Proshares Ultra S&P 500 ETF  , for example, seeks to provide daily investment results that correspond to 200% of the daily performance of the S&P 500 Index. As a result, if the S&P 500 rises 1% the ETF will rise 2%.

While these strategies aren’t for everyone they could be appropriate for investors looking to limit their risks or take advantage of the volatility in the market should consider.

© 2009 CNBC.com