Volatility

Because the actual calculation, and sometimes even the discussions, of volatility involve some fearsome mathematics, novice options traders often forgo learning about it. Those traders are at a disadvantage compared to their more intrepid competitors. And unnecessarily so, since the concept is not only useful but simple to understand.

In essence, volatility is a measure of how much and how fast prices are likely to change. Will MSFT (Microsoft), currently at $27 increase to $28 in the next hour, or fall to $26? Does it continue to fluctuate like that for the day, or several days? Those are wide price swings in a short period – hence high volatility.

The issue is important since, if the price changes slowly, investors will have time to react. If the price changes by an extremely small amount, there is little to lose or gain. Both factors are important in measuring risk.

Mathematicians and options researchers being restless and curious people have naturally not stopped there. They’ve devised several different ways of defining and measuring volatility.

The most basic uses a statistical concept called ‘standard deviation’. While the calculation is complex, the idea is simple. It’s basically just a measure of how far from an average a certain amount differs (i.e. deviates). That calculation, carried out for data covering a year and then massaged a bit, becomes the figure shown in charts.

A variation on that number, called Implied Volatility (IV), uses factors you would intuitively expect: market price, strike price, expiration date, interest rate.

Why should a trader care?

One reason is that IV tends to increase when the market is bearish and decrease when the market is bullish. Common sense reveals why.

If it’s August in the Northern Hemisphere, say New York, and the temperature is 80 degrees (Fahrenheit), how likely is it to deviate to below 40 at noon? If it’s late February, 40 degrees at noon isn’t at all unlikely, but in August it would be surprising.

That deviation from the norm, and the measurement of its likelihood forms the basis of betting on future movements. (In fact, there are option-like derivatives known as Weather derivatives that do just that.)

If it were August in New York, traders would be bullish that it would rise above 70F. (It often does.)

How can a trader use volatility in evaluating trades?

Volatility is one common measure of risk and options are fundamentally about trading risk. One of the most widely used gauges of that volatility is VIX (Volatility Index). First developed by the CBOE (Chicago Board of Exchange), it’s calculated using a weighted average of implied volatility. The data forming that average comes from a wide variety of strike prices for calls and puts from the S&P 500.

Traders use VIX to gauge market sentiment, with a range of 20-25 indicating a probably sell-off. VIX increases as the market goes down and decreases when the market moves up. Again, common sense suggests an obvious reason.

Since volatility implies uncertainty, traders tend to be less concerned about a rising stock market than a falling one. Though shorting certainly forms part of many trading strategies, most traders look to gain from higher prices, not lower.

The higher the perceived risk, the higher the implied volatility and the more expensive options become. As the market declines, puts become more popular. Since traders generally expect the trend to continue (at least in the short term), committing to buy at a lower price becomes a preferred position. Higher demand means higher prices – in this case, for puts.

Tracking volatility should form part of any trader’s strategy. Fortunately, one doesn’t have to be a mathematician to incorporate this tool. Software that calculates and tracks the common measures of volatility are readily available. Add it to your toolbox.

Hedging, Trim Risks Not Bushes

Options are frequently used in hedging.

A hedge is an investment made to offset the risk incurred by entering another investment. Ironically, the basic idea is to bet against oneself, in a way.

Speculate that the market price will rise in the future and buy a call today. (A call is an option that confers the right to buy an asset at a set price in the future.) But, knowing that any price rise is uncertain, simultaneously buy a put. (A put is an option to sell at a preset price in the future.)

Now, why would anybody do such a crazy thing?

Well, hedging is, at bottom, a form of insurance. Though there are traders who use it more actively as a profit seeking strategy, such as hedge fund managers. By carefully selecting the appropriate combinations of strike price, expiration date and type of option an investor can minimize risk and maximize the probability of making a profit.

How?

As an example, we’ll consider a common hedging strategy: the Strangle. No, that’s not something you do to your broker. That would be increasing risk, not minimizing it.

In this strategy, an investor holds both call and put options with the same maturity, but with different strike prices.

The contracts are purchased ‘out of the money’ and are therefore cheaper. ‘Out of the money’ means the strike price of the underlying asset is – higher (for a call) or lower (for a put) – than the current market price.

Suppose Microsoft (MSFT) is currently trading at $30 per share. Buy one call at $3 and one put at $2 with the call having a strike price of $35, the put $25. (Total Investment = ($3 x 100) + ($2 x 100) = $500.)

If the price over the length of the contracts stays between $25 and $35 the total possible loss = $500, the cost of the options. Therefore the risk (‘exposure’) is limited to $500.

Suppose the price drops near expiration to $15. The call would expire worthless, but the put is worth ($25-$15) x 100 = $1000 – ($2 x 100) = $800. Subtract the cost of the call, $800 – $300 = $500. This represents the net profit (ignoring commissions and taxes) on the trades.

The difference between the exposure and the potential profit represents a kind of hedge. Though the investor is, in a sense, ‘betting’ that the price could go either way, his downside is limited to the combined cost of the put and the call.

There are, not surprisingly, nearly as many hedging strategies as there are investors. A couple of common types are:

The collar: Hold the underlying asset and simultaneously both buy a put and sell a call of the same asset. The short call limits gains, but the long put hedges against any losses from the underlying asset.

The protective put: Buy the asset and also buy a put option on the same asset. At expiration, the asset may have gained (eliminating the value of the put option), but the rise in the asset offsets the loss.

Exotic combinations abound, but most involve speculating on the price direction of the underlying asset, while taking advantage of the leverage, cost and timing characteristics of options. As with any investment strategy, make sure you understand the pros and cons before laying down your bet.

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