Category: Your Money

We discussed historical and implied volatility previously. The question now is how to profit from it. As you can see from the chart on the left, the market implied volatility (VIX) keeps oscillating (greed-fear-greed-fear…) A simple strategy could be to sell when VIX is at its lows (greed is predominant) and buy when VIX peaks (fear is predominant). Notice the (loose) correlation between Nifty peaks/troughs with the VIX troughs/peaks.

Buy why trade the underlying (in this case, the Nifty), when you can trade volatility directly? Using stock & index option strategies, you can profit from volatility while being indifferent to the actual underlying scrip. For example, you can buy Straddles (Nifty August 5200 Long Straddle) that appreciate in value if volatility increases, irrespective of whether the underlying stock increases or decreases in value. Ditto with Strangles (Nifty August 5200/5300 Strangles).

Volatility strategies are often used when the fundamentals of the underlying scrip is in doubt. For example, there was a fair amount of uncertainty around INFY results: global IT spending slowdown plus company specific problems. However, it has a track record of execution and is considered to have good corporate governance (ie, a good company to own long term.) So instead of taking a directional bet on the stock, traders put on straddles betting on volatility instead.

To conclude our discussion:

• Choose low-volatility stocks for your long-term portfolio
• Know the difference between historical volatility and implied volatility
• Know what you are trading (fundamentals vs. technicals)
• Be aware of the different trading instruments available to you and know when to use them

Previously, we discussed historical volatility – a measure of volatility already exhibited by the stock. However, history, in and of itself, doesn’t tell you much. There’s another measure, called “Implied Volatility” (IV, for short) that embodies the market’s expectation of future volatility. IV is a useful gauge of the uncertainty “priced-in” by market participants. The chart on the left gives you a comparison between the near maturity IV of ATM calls vs. historical volatility exhibited by INFY.

So what exactly is IV? One of the inputs for the Black–Scholes-Merton model for option pricing is volatility. When you use historical volatility for this input, the price calculated by the model doesn’t match the price at which the market is trading that option. So IV is that value of volatility that brings the output of the BSM in-line with the market price.

How exactly is IV useful? IV allows you to determine a stock’s one-standard deviation move (a stock tends to stay within its one standard deviation move 68% of the time.) If the market is “right”, IV should lead observed (or spot) volatility. So if you plan to hold a stock for less than three months, you should be watching the ATM IVs of the on the run option as well.

Implied Volatilities are specific to stocks who’s options are traded. It is very hard to generalize the IV of one scrip to a sector or the market. That’s where VIX comes in. India VIX is a volatility index based on the NIFTY Index options. From the best bid-ask prices of NIFTY Options contracts, a volatility figure (%) is calculated which indicates the expected market volatility over the next 30 calendar days. For example, if the VIX is 15, this represents an expected annualized change of 15% over the next 30 days; thus one can infer that the index option markets expect the NIFTY to move up or down 15%/√12 = 4.33% over the next 30-day period.

Implied Volatility and its market aggregate, the VIX, are key gauges that any investor should track on a regular basis. A big variation usually signals “something” is afoot and allows the investor to position himself appropriately. When possible, you should always combine historical volatility and implied volatility to get a true sense of where the underlying stock or index is headed.

Volatility is probably the most widely used but poorly understood concept in finance. When people talk about volatility, they are usually referring to historical volatility. Historical volatility is quite simply, a measure for variation of price over time.

If you look at the chart on the left, you can immediately tell that the stock is highly volatile. The daily candlesticks are long and you see prices break through Bollinger Bands frequently. For an investor, volatility can be, at times, gut wrenching. You might see your stops taken out the day the stock closes up 10%.

Investors in blue-chips might think that they are immune to volatility. That maybe true in bull markets, but in the side-ways/bear that we are in right now, volatility affects everybody.

By definition, the annualized volatility σ is the standard deviation of the instrument’s yearly logarithmic returns. The math behind calculating volatility gets trickier while adjusting for:

1. Gaps: if you only use closing prices (close-to-close volatility), then you are not accounting for gap-up and gap-down opens – i.e., stocks don’t necessarily open where they closed the previous day.
2. Dividend ex-dates: if the stock is paying out significant dividends, when it goes “ex”, your vol will be wrong

What does high volatility have to say about returns? Absolutely nothing. Volatility does not measure the direction of price changes, merely their dispersion. Also, a stock that has a volatility of 1% does not move 1% a day on average. (Taleb)

A sudden spike in volatility can spark a renewed interest in the scrip for speculators and is often used by momentum-chasing strategies to screen for stocks. For example, CMC, SUNDARMFIN, BLUESTARCO and MONSANTO are showing volatilities above their historical averages. Volatilities also spike around earnings seasons, something that option traders take advantage of (more on that later.)

Historical volatilities are important while considering investment/trading decisions. It affects where you put your stops and your time horizon. Higher volatility in long term investments result in a wider distribution of possible final portfolio values, so if you are looking to invest for your retirement, stay away from highly volatile stocks.

Remember: Higher volatility implies higher Risk, and may not come with higher Reward.