As the Dust Settles, WMD Evidence Mounts...

As the dust settles from Monday’s flash crash, we’re starting to get a better picture of what actually happened.

It turns out the carnage can be traced back to a kind of financial “weapon of mass destruction” — or WMD. Traders regularly use these instruments to siphon cash out of the market. But one wrong move, and BOOM! — as we saw firsthand earlier in the week.

So today, we’re going to shine the light on this dangerous weapon, and also look at what you can do to protect your wealth and profit from the fallout…

Warren Buffett Exposes “Lethal Danger”

The instruments I’m talking about are called derivatives. They’re simply side bets that investors and traders make on different market movements. While that might sound innocent, legendary investor Warren Buffett had scalding words about them:

“In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal” 

Even though the “Oracle of Omaha” said this in 2002, the truth of his words still rings true today. Derivatives can be very dangerous when used incorrectly. Like the shockwave from a nuclear explosion, their effects can cause devastation over a widespread area.

Just look at how one class of these derivatives created a tsunami of selling across the entire global stock market.

Volatility Derivatives Trigger a Nuclear Reaction

It’s no secret that the market has been uncharacteristically quiet for the last several years. Heck, the S&P 500 hadn’t experienced a back-to-back daily drop of one percent or more for about two years. That’s unprecedented!

As is often the case, the Wall Street geniuses created an invention to bet on the market continuing to stay cool, calm and collected. The invention was “short volatility” strategies.

The terminology sounds complicated. But the idea is simple.

New futures contracts, option contracts and even ETFs that trade like stocks were introduced.

These inventions allowed investors to make long-term bets that the market action would be quiet. And as long as everything stayed under control, these investors would print money day after sweet and serene day.

For a while, it worked fine. But then came the storm.

Below is a chart of the CBOE Volatility Index (VIX) — often referred to as the “VIX” (pronounced “Vick’s”)

Market Calm chart

Volatility started to pick up when traders reacted to a minor uptick in inflation data. The inflation information itself wasn’t a big deal. But as a few traders started selling some shares, it triggered a chain reaction in these nuclear WMDs for the market.

Chain Reaction of Panic

The “peaceful and calm” bets have an interesting twist…

Essentially, the best way to offset a rise in volatility is to sell shares of stocks. (It’s a bit more complicated than that, but you get the general idea).

This week, as traders sold shares to offset their volatility risk, the market naturally fell lower. This caused more volatility, which naturally led to more market selling. The chain reaction fueled itself causing stocks to trade lower and lower until panic set in on Monday afternoon.

Eventually, buyers stepped in to take advantage of the discounted stock prices. But not until these financial WMDs had caused a near 1,600 point drop in the Dow — triggering panic across Wall Street.

It’s a bit ironic because not much (if anything) actually changed for the companies that make up the stock market. But many investors scrambled to sell stocks simply because the market was trading lower.

Unfortunately, this is a recipe for disaster…

An Investor’s Mantra: Buy Low, Sell High

As investors, our best profits are going to come when we buy stocks (or other investments) at a low price and sell them at a high price.

Of course, the simplistic “buy low, sell high” strategy is easier said than done.

But if you want to improve your results as an investor, it is important to keep this concept in mind. When stocks trade sharply lower — and when nothing has actually changed for the companies behind these stocks — it’s usually a very bad idea to sell your shares.

After all, you’re getting a lower price for selling, and you’re likely to turn around and buy stocks — at a higher price — when the coast looks clear! Not a very sound strategy when you think about it.

This is why I always recommend investors stay allocated into different areas of the market, and even into different asset classes entirely (including real estate, gold, and more). I even suggest consistently holding cash in your account so you can take advantage of unexpected pullbacks like we’ve seen this week.

Now, I’m not predicting that the selloff is entirely over at this point. It may be that the market needs to sell off more in order to clear out the excesses that have built up over the past two very calm years.

But I am saying that a balanced approach to investing will protect your wealth against short-term drops in the market. And holding cash to buy shares of your favorite companies when they go on sale is a great way to “buy low and sell high” — which is something most investors don’t have the discipline to do in practice.

Here’s to growing and protecting your wealth!

Zach Scheidt

Zach Scheidt
Editor, The Daily Edge
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