Tag: volatility

Volatility

Introduction

Historical volatility and implied volatility.
Read: Part I, Part II

Nifty volatility

Density plots of historical volatility over different horizons.
Read: Large Moves Happen Together, NIFTY Volatility, Historical Perspective
Charts that are updated often: Volatility and VIX Charts

Dollar ETF volatilities

When you convert Indian indices to dollars, their volatility profile changes.
Read: INDA vs. SPY Observed Volatility

VIX – Implied Volatility Index

Do VIX indices across markets have any relationship with each other?
Read: India VIX vs. SPX VIX

Can a simple VIX based trading strategy avoid market losses?
Read: Macro Volatility and the NIFTY 50, VIX and Equity Index Returns, Part I, Part II.

Can VIX be predicted using a simple model?
ARMA + GARCH to Predict VIX

Macro Volatility and the NIFTY 50

This post is a continuation of our exploration of trying to use macro market indicators to time the NIFTY 50. See World Markets and the NIFTY 50 and India VIX vs. SPX VIX.

Perhaps the problem with using price moving averages was that the major moves were already done before we could short the NIFTY. What if we used volatility instead? Here is how the median of 10-day volatility of major world indices looks like:

macro.volatility

What if we went long only when volatility was below the median and went short otherwise?

macro.trade.a

Looks like the strategy works only in avoiding the 2008 crash. Using observed volatility to time trades doesn’t work. One more to the reject pile.

INDA vs. SPY Observed Volatility

The iShares MSCI India ETF (INDA) tracks the MSCI India Total Return Index, representing about 85% of the Indian stock market. As a follow up to our earlier post on the historical volatility of the NIFTY historical NIFTY volatility, we thought we’ll compare the volatilities of INDA and SPY, the S&P 500 ETF.

10-day volatility:
INDA.SPY.volatility.density.10

50-day volatility:
INDA.SPY.volatility.density.50

As expected, a dollar denominated emerging market ETF is more volatile than the S&P. File this away in your brain attic.

NIFTY Volatility, Historical Perspective

Was 2014 an anomaly?

Here’s a density plot of NIFTY volatility across 10-, 20-, 30-, and 50-day periods:

NIFTY.volatility.density.2014

And here’s how it was in 2004 (10-years ago):

NIFTY.volatility.density.2004

For those of who argue that the introduction of the pre-open auction call in 2010Gaps and the Pre-Open Call Auction skews these results, here’s how 2011 looked like:

NIFTY.volatility.density.2011

The unprecedented absence of a second “hump” in the volatility density plot for 2014 should give pause to investors looking for a repeat of 2014 anytime soon.

Reversion to higher volatility?

If you look at the 50-day volatility over different time-periods, you can observe how volatile volatility is:

NIFTY.volatility.density.50

This year’s observed volatility is closer to last-year’s than to its long-term mean. Here’s how 2015 has panned out so far:

NIFTY.volatility.density.2015

We should expect higher volatility as the initial bull-run wears off and volatility reverts. This will have a ripple effect on pretty much every investment/trading strategy.

Appendix

Year-wise NIFTY volatility density plots (pdf)

Butterflies

Introduction

The butterfly can be used to bet on underlying volatility and is cheaper than straddles and strangles and without the unlimited risk.

Bearish outlook on volatility

A long call butterfly can entered when you think that the underlying stock will not rise or fall much by expiration. Using calls, the long butterfly can be constructed by buying one lower striking ITM call, writing two ATM calls and buying another higher striking OTM call.

For example, with the Nifty trading at 6780, that means entering into an April 6700/6750/6800 Long Call Butterfly. If the Nifty ends between 6712.00 and 6788.00 at expiry, you make a profit of Rs. 1900.00 and your downside (max loss) is limited to the premium you paid (Rs. 600.00)

April NIFTY 6700-6750-6800 Long Call Butterfly

April NIFTY 6700-6750-6800 Long Call Butterfly payoff
April NIFTY 6700-6750-6800 Long Call Butterfly PL

The same outlook can be expressed using puts. For example, with the Nifty trading at 6780, you can enter into an April 6700/6750/6800 Long Put Butterfly. If the Nifty ends between 6707.75 and 6792.25 at expiry, you make a profit of Rs. 2112.50 and your downside (max loss) is limited to the premium you paid (Rs. 387.50) In this case, the Long Put Butterfly makes more sense: it costs less, the expected P&L is higher and the break-evens are wider.

April NIFTY 6700-6750-6800 Long Put Butterfly

April NIFTY 6700-6750-6800 Long Put Butterfly payoff
April NIFTY 6700-6750-6800 Long Put Butterfly PL

γ: runs from positive to negative. γ is negative when the stock is at the middle strike. This indicates that the butterfly will manufacture negative δs if the stock price rises, and positive δs if the stock price falls. This is precisely what you don’t want to happen. That’s why the long butterfly wants the price of the stock to stay right where it is when it’s at the middle strike.

θ: positive when the price of the stock is at the middle strike, indicating that time passing helps the long butterfly reach its maximum value. At the outer strikes theta is negative, indicating that the butterfly is losing value as time passes.

κ is negative when the stock price is at the middle strike. That means that any increased implied volatility in the stock will decrease the value of the butterfly. κ is positive for the long butterfly at the outer strikes. Therefore, an increase in the implied volatility of the stock increases the value of the butterfly because of the greater likelihood that the stock will move toward the middle strike by expiration.

Bullish outlook on volatility

A Short Call Butterfly allows you to collect premiums if you can wait out uncertainty. For example, with the Nifty trading at 6780, you can enter into an April 6700/6750/6800 Short Call Butterfly. If the Nifty ends below 6712.00 or above 6788.00 then you lose Rs. 1900.00 (difference in strikes – premium received). Otherwise, you get to keep the option premium you collected (Max: Rs. 600.00)

NIFTY April 6700-6750-6800 Short Call Butterfly

NIFTY April 6700-6750-6800 Short Call Butterfly payoff
NIFTY April 6700-6750-6800 Short Call Butterfly PL

The same view can be expressed using a Short Put Butterfly. For example, with the Nifty trading at 6780, you can enter into an April 6700/6750/6800 Short Put Butterfly. If the Nifty ends below 6707.75 or above 6707.75 then you lose Rs. 2112.50 (difference in strikes – premium received). Otherwise, you get to keep the option premium you collected (Max: Rs. 387.50)

NIFTY April 6700-6750-6800 Short Put Butterfly

NIFTY April 6700-6750-6800 Short Put Butterfly payoff
NIFTY April 6700-6750-6800 Short Put Butterfly pl

θ: helpful when the position is profitable
δ: greatest around the outer strikes, zero around the middle strike
κ: volatility is helpful, unless the underlying moves outside the outer strikes
γ: peaks positively around the middle strike and negatively around the outside strikes

Trading butterflies

You should know the historical volatility of the underlying and its distribution before you get into volatility trades. As a rule of thumb, always try to position your derivative book towards being long volatility.

If the bid/ask spread is too wide, it can affect the quality of the trade. Since the losses are capped, running this trade to expiry may be tempting in such a scenario.

Source: ThinkOrSwim