(Updated November 2021)
Volatility traders do not pay attention to which direction stock prices move, they are interested in the level of volatility itself.
Volatility trading describes trading the volatility of the price of an underlying asset. Make a note of the difference, it isn’t trading of the price itself. Or in other words, volatility trading indicates trading the assumed future volatility of the index. Hence, it is buying and selling the anticipated future volatility of the asset. Every single asset in which price changes, actually manifests price volatility. So, traders that trade volatility looks at how much change, in any direction, will happen. They don’t pay attention to the price, they don’t want to predict the price itself. Such traders just think about how much the price of some asset will move in the future, in the stock price, for example. No matter if it will go up or down. And it isn’t random trading. They have developed strategies which we’ll present to you.
But firstly, we would like to make clear what volatility trading is.
For example, options are a favorite tool for volatility trading. Why is that? Well, many factors can affect the value of the option but a crucial for its value is the expected future volatility of the underlying asset. Hence, options with higher expected volatility are more valuable than options on instruments with low expected volatility in the future.
Therefore, options represent an easy way to get exposure to the volatility of the underlying instruments. Basically, that expected future volatility of the underlying instrument of an option is a very important part when traders’ valuing the option.
Factors important to determine the volatility
We can recognize seven factors that determine the price of an option and they are also called variables. While all of them are variable only one is an estimate and represents the most important part. The known factors are the current price of an underlying asset, strike price, also the known part is calls and puts, meaning what is the type of an option. Further, we always know what is the risk-free interest rate, and the dividends on the underlying assets. But what we don’t know is volatility. The volatility is the most important variable to determine the price of an option. So we need to know what indicates volatility.
First of all, it is one of the “Greeks” – Vega.
It is the measure of an option’s price sensitivity to shifts in the volatility of the underlying instrument. Vega outlines the value that an option’s price changes as a response to a 1% move in the expected volatility of the underlying asset. This “greek” will show the change of an option for every 1% of the change in volatility.
Main points related to volatility trading
Traders should pay attention to two main points related to volatility.
One is relative volatility. It refers to the current volatility of the stock in comparison to its volatility over a given period. For example, ABC stock options that expire in one-month historically showed expected volatility of 15%, but current volatility is 25%. Let’s compare it with XYZ stock options that had expected volatility of 25% but now grown to 30%. If we want to estimate absolute volatility it is obvious that XYZ stock has a greater. But the stock ABC gained a greater change in relative volatility.
The volatility of the overall market is important too. The most used is VIX ( the CBOE Volatility Index) that measures the volatility of the S&P 500. VIX is also known as the investors’ fear gauge. When the S&P 500 experiences a sharp decline, the VIX increases sharply. Every time when the S&P 500 is rising gradually, the VIX will be pacified.
Strategies for volatility trading
Straddle strategy
As we said, traders who trade volatility are not interested in the direction of the price changes. They make money on high volatility, no matter whether the price goes up or down.
One of the most popular strategies for volatility trading is the Straddle strategy with pending orders. This strategy provides a profit when the price goes considerably in one direction, no matter if it is up or down. The best time to use this strategy is when the traders expect an extreme increase in volatility.
We said it has to be used with pending orders. The pending orders are orders that were not yet executed, hence not yet becoming a trade. They’ll become market orders when certain pre-specified conditions are met.
If you want to use this strategy, you’ll need to identify a market in consolidation before some significant market release. Further, set a buy stop pending order above the upper consolidation resistance. A sell stop pending order you should set below the lower consolidation support.
In Forex trading
For example, you are trading Forex and have a currency pair that entered a consolidation stage with low volatility. Just put buy stop orders a few pips above the upper resistance, so a sell stop order should be a few pips below the lower support. No matter in which direction the price will change, it will trigger one of these orders and when the volatility continues, the trade will end up in a profit.
The real trigger for pending orders is volatility. Volatility occurs a bit before important reports in the market and traders usually schedule this kind of trades before them.
In a straddle strategy, the traders write or sell a call and put at the same strike price wanting to receive the premiums on both positions. The reason behind this strategy is that the traders await expected volatility to decrease significantly by option expiry. That allows them to hold most of the premiums received on short put and short call positions.
Ratio Writing
Ratio writing is simply writing more options than are bought. Use a 2:1 ratio, just two options, sold or written for every option bought. The aim is to profit on a large fall in expected volatility before the date of expiry.
Iron Condors in volatility trading
In this strategy, the traders combine a bear call spread with a bull put spread of the same expiration. They hope to profit on a reversal in volatility. The result would be the stock trading in a tight range during the life of the options.
The iron condor strategy has a low payoff, but the potential loss also has a limitation.
Go long
During the high volatility, traders who are bearish on the stock can buy puts on it. Keep in mind the saying “the trend is your friend.”
“Go long” strategy or buy puts is expensive. It requires, from traders who want to lower the costs of long put positions, to buy more put out-of-the-money or, the other way is to add a short put position at a cheaper price to meet the cost of the long put position. You can find this strategy under the name a bear put spread.
Go Short
The other name for this strategy is “write calls”. The traders who are bearish on the stock but think the level of expected volatility for options could decrease may write naked calls to pocket a premium.
Writing or shorting a naked call is a very risky strategy, keep that in mind. There can be an unlimited risk if the underlying stock boosts in price before the expiry date of the naked call position. In such a case, you can end up with several hundred percent of the loss. To reduce this risk, just combine the short call position with a long call position at a higher price. This strategy you can find under the name “a bear call spread.”
Use VIX to predict the volatility
Yes, you can recognize market turns by using VIX. To be more specific, you’ll recognize the bottoms. Well, the stock market regularly rises gradually and the VIX will decrease in the same manner. So very low levels can occur. The investors don’t feel they need any protection. If these periods last longer, the VIX as a sell signal can be useless.
But, the nature of the S&P 500 is long-biased. If index declines investors start to buy protection (simple put options) fast. That pushes up the VIX. Can you see how great the “fear barometer” VIX is? When you notice a high VIX you can be sure the investors and traders are overreacting because the market drops. The VIX during times of market drops will behave as the spike. That is a good signal to discover when selling is overdone and the market is moving higher due to bounce or even bottom for a longer-term.
This strategy is suitable when the VIX ‘sign’ appears during a bullish trend in the S&P 500.
Bottom line
Volatility trading is an excellent way to get profitable trades even if you are wrong about the direction of the price. Volatility is the main interest of volatility traders. They are seeking big changes in any direction. Use the VIX index as a measurement for volatility in the stock market. A rising VIX index indicates fears in the market. But it is a good time to buy stocks. The most popular trading strategy to trade volatility is the Straddle strategy.
Also, traders use the Short Straddle strategy when they expect a lack of volatility, for example, the prices continuing with steady change.
No matter which of these strategies you want to use, just keep in mind that you can profit no matter what is the direction of the price movement.