When volatility increases, along with the risk, the opportunity to profit also increases. To profit from the market volatility one has to develop the right point of view on where volatility is heading
Volatility is an inherent virtue of markets. An active trader has to learn how to deal with market volatility. If you ask a typical trader what volatility really is, he is most likely to say “it’s the up-down movement of the market”.
Well, it is not just that. Volatility, as measured by the standard deviation of daily returns of the index (or stocks), represents the riskiness of the market. If the volatility is increasing, it means the market swings are getting wilder and hence the riskiness of the markets.
When volatility increases, along with the risk, the opportunity to profit also increases. To profit from the market volatility one has to develop the right point of view on where volatility is heading.
To develop such a point of view, one can track the India VIX index and compare it with the historical levels. Also, do bear in mind that whenever any important market events such as the budget, election, corporate result announcement, RBI monetary policy meet is around the corner the volatility always increase.
The best way to profit from the variation in volatility is by employing options strategies. The best part of option-based volatility strategies is that you need not be right about the market direction, the market can head either way, and it would not matter.
The underlying premise is that the option premium increases when the volatility increases. This is because when volatility increases the probability of the option expiring in the money also increases, hence the premium increases.
Conversely, when volatility is expected to reduce, the option premiums are also likely to reduce. Based on your view on the volatility and the time to expiry, here are few option strategies that you can follow -
1. When you expect the volatility to increase it means the option premiums are going to increase as well, hence one needs to be an options buyer.
2. If there are more than 15 days to expiry from your trade date, then build a strangle strategy by employing 1 OTM Call option and 1 OTM Put option.
3. If the days to expiry are less than 15, then buy a straddle by employing 1 ATM call and 1 ATM Put option. This will help you benefit from the increasing premiums.
4. When you expect the volatility to decrease, it means the option premiums are going to decrease as well, hence one needs to be an option seller.
5. Sell naked deep OTM options if there are more than 15 days to expiry from your trade date, else sell OTM options that are slightly away from the ATM mark.
In fact when there are less than 15 days to expiry and the volatility is likely to reduce you can benefit in two ways - time decay and drop in volatility. Do remember selling ATM options can be a little risky, hence best to avoid it.
Also in the backdrop of an important market event, the volatility would shoot up as the event approaches and would eventually drop after the event unfolds.
For example, assume the RBI monetary policy is scheduled to be announced tomorrow. The volatility would start to increase few days prior to the event (or stay at a higher level) till the event day; once the announcement is made the volatility almost always drops, thereby reducing the option premiums.
Now in a situation like this, the market will move based on the outcome of the event, hence selling naked options can be risky. Therefore one can sell a straddle and benefit from the falling option prices.
Assume you have set up a short straddle in the backdrop of the RBI monetary meet. Let us say RBI decides to cut the rate, this is good for the markets and therefore the markets are likely to go up.
What is likely to happen is that the Put option premiums will erode much faster than the increase in call option premiums, hence the short straddle would work in your favour.
So, the next time whenever you have a view on volatility, do not just blindly speculate on the market direction instead employ an options strategy!Disclaimer: The author is VP, Educational Services, Zerodha. The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.