Volatility Trading Strategies-Using Derivatives to magnify your wins!
When longer term investors hear that volatility is coming into the markets, they look for the closest rock to hide under. However, one should embrace volatility. Even investors!
With these volatility trading strategies, both investors and traders will learn to welcome volatility when it comes around. Volatility should no longer be a traders wish!
In the following article, TRADEPRO Academy will go through some volatility strategies traders and investors can use in the options market.
Volatility Trading Strategies-Options
There are several ways to take advantage of volatility in the options market. Throughout this article we will go through 5 volatility strategies that all encompass options!
Some of the following strategies involve using the Greeks in options to take advantage of potential upcoming volatility.
Volatility trading strategies that involve options can be used as a hedging mechanism or speculative mechanism. In which a trader or an investor look to make a substantial profit through the increase of volatility.
There are two general classifications of volatility that we will talk about throughout the blog. They are historic volatility and implied volatility.
Historic volatility is known as statistical volatility. It is a measure of the speed of the assets change in price over a specific time period.
Implied volatility is a future value of volatility predicted by market participants. It suggests the magnitude of a change in an asset price over a certain period of time in the future. Generally when options markets drop, implied volatility increases.
One thing to note is with the increase in implied volatility, there is an increase in option premium value. So in times of high volatility options premium is more expensive to either buy or sell. When a stock
Volatility Trading Strategies- Implied volatility trade
The direct implied volatility trade is quite simple, trade the VIX options! The VIX represents market volatility in an index. It is the expectation of the S&P 500 index options volatility. If the expected (implied) volatility of the S&P 500 index options is about to rise, you will see a bull run on the VIX. Alternatively, if we expect low volatility in the index options, VIX will remain low.
A bullish VIX is driven by large volatile drops in the S&P 500 index. We saw all time highs on the VIX in 2009 when the financial markets crashed. The VIX pressed above the 100 level. In this case, call options on the VIX would made traders handsomely profitable.
In recent months we’ve seen drastic drops in the S&P 500 and other equities. This correction helped the VIX reach new highs, many might have heard “long VIX”. Implying that volatility was expected to spike on this downside. However the VIX did not climb near the 2009 highs.
Alternatively, in summer months when there is little movement in the S&P 500 to either side, we expect low bursts of volatility. In this case, we expect the VIX to stay low and sideways. A way to exploit this price action would be to write credit spreads on VIX options for premium.
Example of VIX trading
The chart below represents the VIX index from February 2017 to present day. The slower summer months where one can write credits spreads to generate passive income on the VIX are outlined with an orange box. The reason for this is that volatility is usually low in the summer. The green box alternatively represents periods of high volatility which come in the fall or winter. This is when volatility spike on S&P 500’s downturn. Presenting traders with the opportunity of getting long the VIX using calls.
Volatility Trading Strategies-The Greeks
The Greeks are avoided by many people out there, as they can seem a little confusing. Fear not, the Greeks are your friends! They will help you exploit volatility in options to generate immense profits.
In this section we will introduce two Greek options symbols that will help you when volatility comes into markets. Vega and Gamma.
For simplicity sake, we will give you a basic definition of the two Greeks. However the bulk of this section is geared towards exploiting Vega and Gamma for volatility trading. Click here for an in depth article on Gamma.
Basically, Vega is the measure of the change in the option’s value for a change in the expected volatility. Vega is based on a 1% change in implied volatility. For example, if an options Vega 0.20 and implied volatility increases by 1%. We would expect that the value of the option would increase by $0.20.
Now, how do we take advantage of Vega and Gamma during volatile times?
Volatility and Vega
First, Vega trading. If one thinks that implied volatility is due to rise, to correlate with actual volatility being high. A trader may look to get long options straddles in order to become long Vega. Alternatively, if implied volatility is currently above actual volatility and is expected to drop in the eyes of the trader. The trader can sell options straddles in order to become short Vega.
Volatility and Gamma
Next comes Gamma trading in volatile environments. This involves a very similar strategy to the one above. However this time a trader looks to play Gamma against Theta. In the same scenario as above, if you expect implied volatility you can enter in a long options position, which means you are long Gamma, hoping your gamma profits outweigh Theta losses (depending on expiry). Alternatively, if you think implied volatility is too high, and you sell options to enter into a short Gamma position or Gamma hedge. In this scenario Theta works for you as you collect the premium, however, profits of the Theta burn will have to outweigh losses from the Gamma hedge.
Volatility Trading Strategies-Straddles and Strangles
Finally, there is an options trading strategy that is of high probability in terms of predicting volatility and exploiting it for gains. This opportunity comes around once a quarter per stock, but not all stocks. Yes, I am referring to earnings trading!
In this case, it is not a gamble as to what direction the stock will spike based on earnings, but its the exploitation of the implied volatility a month prior to the earnings season and leading up to the report. The volatility that comes into the earnings expectation is built up on pure anticipation and uncertainty. An increase in uncertainty of earnings increases a stocks implied volatility.
However, not all options on stocks are guaranteed to spike in implied volatility a month prior to the earnings report. It is important to check how historic volatility in that stock has behaved prior to earnings.
Straddles and Strangles
The idea behind this strategy is to buy options strangles or straddles one month or a little more prior to earnings to take advantage of the spike in implied volatility and dump the position a day or two before the report.
Both the put and call of the options strangle or straddle should increase in value as implied volatility increases, regardless of the move of the stock, as long as the move is not massive to either side.
Selling the position before the report ensures that profits are not taken away as implied
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The information contained in this post is solely for educational purposes, and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.