How To Use Volatility For Profits

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How To Apply Volatility

How To Apply Volatility To Binary Options

Volatility is your friend, as I explained in a recent post. This is because volatility means movement, and movement means pips and pips means profits. Profits are why we are here, yes there are a wide variety of secondary reasons to be in the market but it always comes back to profits. Volatility is something that traders of more mainstream vehicles watch closely as it implies risk levels as well as pricing for things such as options and futures contracts. Traders of these assets can and will adjust their strategies from buy to sell and from long to short as the conditions warrant and these decisions are often based on the volatility. In fact, there are even indices, such as the VIX, that track volatility and can be traded. This is one way for a binary trader to use volatility to his or her advantage but not the only way. As a measure of market movement it can be used in a number of ways and there are a few different indicators based on volatility to choose from.

  • Volatility is a measure of market movement that is unconcerned with direction. It measures the amount of movement on a day to day basis, relative to historic movements, and is often used as an indication of risk. Lower volatility assets move less and present less risk whereas higher volatility issues move more and have higher associated risk.

As a trader you can apply this theory in two ways. First you can search the market for likely trades and rank them based on a measure of volatility. If you are a less risky traders you may want to trade a less volatile asset, if you are a more risky trader you may choose to trade higher volatility assets. The second way, and the method I like best, is to stick with one asset and adjust your strategy as volatility warrants. I myself like to trade the S&P 500 so it is very easy for me to use the VIX as a measure of volatility. Some other, but not all, indices also have a volatility index such as the NASDAQ Composite and the VXN. Likewise, some, but not all, binary options brokers have options on the VIX and/or the VXN.

You can use volatility to track short term market cycles in order to adjust strategy and gain profitable entry points. Over time the every asset will go through periods of higher and lower volatility, and this could be in either direction, up, down or sideways. My caveat is that you must always take into account the underlying trend in the asset when applying volatility in this way. When volatility is low it is usually a time to buy, either a call or a put depending on circumstance. This is because the market has cooled off from previous movement and price action has calmed down. You will be able to get better positions, with better entry points and higher rates of profitability. Then, when the market moves, your options will move well into the money with less chance of loss, or breaking even which I think is worse.

Indicators For Measuring Volatility

There are several prime indicators used by professional traders every day. These include a number of oscillators as well as Bollinger Bands ™. Bollinger Bands ™ are a proprietary method of trading that utilizes envelopes and channel theory along with volatility to find entry and exit points in commodity markets. The great news is that it works equally well on charts of any financial instrument. They are based on standard deviations of price movement relative to a central moving average. Signals are given when the bands move closer and further apart, when prices touch or exceed on of the bands and when prices touch or move past the central signal line.

Volatility can be harnesses profitably by binary options traders.

The Relative Volatility Indicator is an oscillator that tracks daily volatility relative to a set period, usually 10, and then smoothed by a 14 period moving average. This produces a indicator that ranges between 0 and 1 with 0.25 low and 0.75 high. If you look at the chart above you can see how the bottoming pattern that forms in the Relative Volatility Index happens when the SPY is touching or moving past the lower Bollinger Band. This is a double confirmation of a low in volatility and trend following entry that produced a move greater than 5% the first time….how much will it produce this time?

Volatility: How you can use it to make profits in trading

Posted on June 1, 2020 by J Crawford in Education, Options, Stocks | 0 Comments

What is Volatility?

Volatility is the amount of up-down movement of the price, of a financial instrument. Here is a list of financial instruments types that are affected by volatility: stock, bonds, currency, index, commodity, etc. Volatility does not measure the direction of price changes. It measures the dispersion of the price. In other words, volatility is a measure of the stability of a financial instrument.

SPX Volatility from Dec – 2020 to Apr – 2020

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*Visit www.cboe.com to get real time data.

How to Calculate Volatility:

How to calculate volatility?

Volatility is usually measured as the standard deviation of the annualized returns. High volatility means that the price of the financial instrument can change drastically in either direction. Low volatility means that change in the price is steady. Thus, high volatility means the financial instrument is unstable, and, low volatility means the financial instrument is stable.

For example, a financial instrument with a volatility of 60% is considered a high-risk investment instrument; as the financial instrument has the potential to increase or decrease up to 60% of its value. Thus, volatility is a key factor in assessing the risk of a financial instrument.

High/Low volatility depends on the perception of the trader based on what an acceptable risk ratio is for that specific person. Ultimately it differs from trader to trader, but this is what I consider high vs low volatility.

A recent market volatility from Feb-17 to Mar-17 is what I would classify as low volatility period.

However, the period from Apr-17 onward is what I classified as a period of high volatility.

Volatility Indicators:

Volatility is mainly indicated by:

1- Historical Volatility of Stocks:

Historical price data of the financial instrument is used to calculate the historical volatility.

It is not a forward-looking measure as it does not tell about the future volatility. Historical volatility is also known as statistical volatility, or, realized volatility.

2- Implied Volatility of Stocks:

Derived from the available market price of the traded options reflects the anticipated future volatility of the financial instrument. Option prices of options expiring in the future are used to calculate the implied volatility. The calculation considers the premium traders are willing to pay for the options expiring in the future. Thus, the implied volatility reflects the future volatility.

Implied volatility, denoted by (sigma), is often referred as “vol; or fear and greed index; or expected volatility.”

Volatility Index:

Introduced by Chicago Board Options Exchange (CBOE), the volatility index (VIX – Index) measures the short term implied volatility in the market. The CBOE VIX Index uses S&P 500 Index option series to calculate the implied volatility, or expected volatility.

Stocks and Volatility:

Beta of a stock is a measure of the relative volatility of a stock to the market. Beta of a stock provides an estimation of the overall return of the stock against the return of a relevant benchmark.

Example:

A stock with a beta value of 0.9 has historically moved 90% for every 100% move in the benchmark; based on price level.

Trading Options of Stock or Index:

The option prices, of puts as well as calls, increase with an increase in the volatility of the underlying asset. Volatility is the most important risk to consider before selling an option. It would be wise to sell an option when the volatility is high, and, to buy the options when the volatility is low.

Example:

Selling an option of a stock just before the release of earnings would be a bad move because the volatility generally increases right when the earnings are being announced, and for a little while after that. I would however, buy an option (if volatility is low) before the release of earnings, and, sell the options when the volatility has increased during, or, after the release of the earnings.

(www.marketwatch.com can be utilized to find about the earnings of almost all the companies traded on any of the major exchanges of US – date of earnings, financial results, etc.)

To profit from an increase in volatility, a trader should buy both, a Call and a Put; when the volatility is low. It would be advantageous to buy an “in the money Call”, and, an “in the money Put”. Suppose, Google is trading at $971 a day before the release of earnings. The trader should buy an in the money (ITM) Call – 967.5, and, an in the money (ITM) Put – 975, for the same expiry (ensure that the options expiration is after the announcement of the earnings).

The Profit/Loss of this position, at different prices of the underlying on expiry:

Other ways of using the Volatility:

1- A few days before the release of Fed minutes (can be found here), everything else being the same, volatility is considerably low. Hence, it would be wise to buy S&P options, and sell them after the announcement of the Fed minutes when volatility is higher.

2- Buy options of Crude Oil before the release of Crude Oil’s supply data – as volatility is low; and sell them after the release of the supply data, when the volatility is high.

*Visit www.cboe.com to get real time data.

Which option to buy in the two scenarios described above?

Buying both a put and a call to construct a straddle (future strategy to come) would be most profitable. There are two reasons for this:

a- With the increase in the volatility, the price of both the put, and, the call would increase; and,

b- There might be a big move resulting in a situation where one of the options (put or call) would trade at a price which would be more than what the trader paid to buy them both.

High Volatility Example:

If the volatility is getting increasingly higher, then selling “at the money” options would be profitable. “At the money” is a situation where an option’s strike price is identical to the price of the underlying security.

But wait, selling naked options is inviting trouble, and, possibly a step towards bankruptcy. You need to ensure that the sold options are always hedged (click here for more info on what a hedge is). The best way to achieve this would be to sell at the money (ATM) option, and, buy out of the money (OTM) option; as a hedge for the sold option – this will limit the loss.

Let’s say that the volatility is high, and the trader expects it to do down.

S&P is trading at 2415. In such a case, trader should

1- Buy S&P Call 2420

2- Sell S&P Call 2415

3- Sell S&P Put 2415

4- Buy S&P Put 2410

Ensure that all the options are of the same expiry.

This strategy gives a net credit of the premium to the trader; as shown below.

Conclusion

When market volatility reaches a certain level, things can start to move so quickly that different tactics may be in order.

The key is to prepare in advance.

The tactics I discussed in this article should serve to give you some potential ideas to consider.

I hope you enjoyed this article on volatility and would love to hear your thoughts on it.

How To Profit From Volatility

Derivative contracts can be used to build strategies to profit from volatility. Straddle and strangle options positions, volatility index options, and futures can be used to make a profit from volatility.

Straddle Strategy

In a straddle strategy, a trader purchases a call option and a put option on the same underlying with the same strike price and with the same maturity. The strategy enables the trader to profit from the underlying price change direction, thus the trader expects volatility to increase.

For example, suppose a trader buys a call and a put option on a stock with a strike price of $40 and time to maturity of three months. Suppose that the current stock price of the underlying is also $40. Thus both options are trading at-the-money. Imagine that annual risk free rate is 2% and annual standard deviation of the underlying price change is 20%. Based on the Black-Scholes model we can estimate that the call price is $1.69 and the put price is $1.49. (Put-call parity also predicts that the cost of the call and put price are approximately $0.2). The cost of the strategy comprises the sum of the call and put prices – $3.18. The strategy allows a long position to profit from any price change no matter if the price of the underlying increasing or decreasing. Here is how the strategy makes money from volatility under both price increase and decrease scenarios:

Scenario 1: The underlying price at maturity is higher than $40. In this case, the put option expires worthless and the trader exercises the call option to realize the value.

Scenario 2: The underlying price at maturity is lower than $40. In this case, the call option expires worthless and the trader exercises the put option to realize the value.

In order to profit from the strategy, the trader needs volatility to be high enough to cover the cost of the strategy, which is the sum of the premiums paid for the call and put options. The trader needs to have volatility to achieve the price either more than $43.18 or less than $36.82. Suppose that the price increases to $45. In this case, the put option exercise worthless and the call pays off: 45-40=5. Subtracting the cost of the position, we get a net profit of 1.82.

Strangle Strategy

A long straddle position is costly due to the use of two at-the-money options. The cost of the position can be decreased by constructing option positions similar to a straddle but this time using out-of-the-money options. This position is called a “strangle” and includes an out-of-the-money call and an out-of-the-money put. Since the options are out of the money, this strategy will cost less than the straddle illustrated previously.

To continue with the previous example, imagine that a second trader buys a call option with a strike price of $42 and a put option with a strike price of $38. Everything else the same, the price of the call option will be $0.82 and the price of the put option will be $0.75. Thus, the cost of the position is only $1.57, approximately 49% less than that of the straddle position.

Even though this strategy does not require large investment compared to the straddle, it does require higher volatility to make money. You can see this with the length of the black arrow in the graph below. In order to make a profit from this strategy, volatility needs to be high enough to make the price either above $43.57 or below $36.43.

Using Volatility Index (VIX) Options and Futures

Volatility index futures and options are direct tools to trade volatility. VIX is the implied volatility estimated based on S&P500 option prices. VIX options and futures allow traders to profit from the change in volatility regardless of the underlying price direction. These derivatives are traded on the Chicago Board Options Exchange (CBOE). If the trader expects an increase in volatility, they can buy a VIX call option, and if they expect a decrease in volatility, thet may choose to buy a VIX put option.

Futures strategies on VIX will be similar to those on any other underlying. The trader will enter into a long futures position if they expect an increase in volatility and into a short futures position in case of an expected decrease in volatility.

The Bottom Line

The straddle position involves at-the-money call and put options, and the strangle position involves out-of-the-money call and put options. These can be constructed to benefit from increasing volatility. Volatility Index options and futures traded on the CBOE allow the traders to bet directly on the implied volatility, enabling traders to benefit from the change in volatility no matter the direction.

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