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.

Post from: Finance Investment Guide

Volatility

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.

Post from: Finance Investment Guide

Hedging, Trim Risks Not Bushes

Trading options is risky. While the risk is limited to the cost of the option (the ‘premium’), that isn’t necessarily small. A Google June 400 call can cost around $2800.

The premium may be only 28, but an option contract is a commitment for 100 shares. Hence the figure is multiplied by 100. Of course, for that commitment the buyer is controlling roughly $40,000 worth of stock. (’Roughly’ since the strike price, $400, differs from the current market price, say $395 at the time of the contract.)

Options, by nature, have an expiration date. (That’s part of what makes them an option.) As that expiration date draws near the worth of that option can rapidly approach zero, depending on the current market price and other factors. Hence, risky.

And that scenario only involves controlling 100 shares - not much in the scheme of things.

One way around these difficulties is to invest instead in a fund. Funds invest in stocks, bonds, commodities, indexes, even futures or options - all the things individual investors themselves trade.

Investors who purchase a fund (a mutual fund or ‘open-end’ fund) own a portion of the instruments the funds buy. The fund is managed by a fund manager, presumably a knowledgeable and experienced investment professional. The fund manager has (in theory, anyway) the available resources, time and expertise to make investments that garner returns superior to what the individual can make himself.

The investor in mutual funds pays a fee for the service, but gets not only expertise and resources but also the advantage of being able to pool funds (hence the name) with other investors. That pooling allows control of many more shares, bonds, etc than the average individual can.

This helps influence prices in that fund’s direction. (If you don’t think so - and considering that many of them lose money skepticism is warranted - look at a chart showing price fluctuation against daily quantity bought or sold by the larger funds. There’s no question that large funds influence stock prices, which in turn can influence their fund’s value.)

For those investors interested in options, but without the time, expertise or capital to profit from them options funds are available.

Make sure you study carefully what the fund actually offers, though. There’s a difference, sometimes overlooked, between an option on or from a fund and a fund that buys options.

Some funds actually purchase options contracts and speculate just as individual options traders do. Since funds control a larger amount of capital than individual investors the ‘multiplier effect’ (leverage) of options investing is increased further.

Other funds, though, actually buy stocks and then issue options to the fund members on those stocks. That’s a different animal. This can produce profits for participants, but are more like short term trades. As the share price rises, the options are just exercised, limiting income growth opportunities.

Mutual fund investors tend to be more interested in the long-term outlook and often seek income growth funds.

The same variety of options available to the individual are, of course, there for the fund manager. Options on stocks, bonds or commodities are commonplace, but one of the newer wrinkles is options on ETFs (Exchange Traded Funds).

Funds that invest in these are actually speculating by buying an option on a fund that’s gambling on an index that measures a basket of stocks. If your head hurts - and who could blame you - maybe you should just buy stock.

Post from: Finance Investment Guide

Funds and Options