Invest Without Emotions
Does implied volatility contain incremental information about future volatility? At least according to this paper, it does.
Here’s a chart that plots USDINR option implied volatility (nearest at the money) vs. futures (nearest expiry). It does appear that IV leads realized vol, but it would be interesting to see if there’s any trading edge here…
[stockquote]ATULAUTO[/stockquote]
You can view a chart of the VIX just as you can for any stock or index. Just go to the VIX page, add some moving averages, maybe even Bollinger Bands and RSI indicators and you are on your way. However, just because you can chart the VIX just like a stock, doesn’t mean you should actually read the chart just like a stock.
Charts for stocks and indices actually represent buying and selling over specific timeframes. Stocks gap up and down. Gaps get filled. Old resistance points can become new support levels, etc. However, VIX is not a stock. India VIX is a volatility index based on the NIFTY Index Option prices. 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. Hence, price points for the VIX doesn’t correspond to potential profits and losses of actual trades based on those levels. Support and resistance and trend lines and momentum effects all depend on the existence of buyers and sellers in the asset being analyzed. But you can’t trade VIX directly, so the VIX can never find “support” because no one previously bought VIX “shares” at that price level. VIX is, at best, an indicator of market expectation of volatility.
However, there are a few useful analysis you could run on VIX, given its tendency towards mean-reversion. Bollinger Bands and moving averages could help you gauge the band within which VIX is oscillating. Longer-term charts could help surface seasonal patterns. StockViz India VIX Charts are another tool in the arsenal for investors to help them make better decisions.
Now that the earnings season is over and Europe is on vacation, volatility in the NIFTY has dropped off. Here’s a historical chart to put things in perspective:
With the August expirations right around the corner, you should be looking at putting on Sep 5300/5400 Long Strangle on the NIFTY or if you are feeling brave, buy the Sep 5000 NIFTY Puts outright.
With the Strangle, you’ll have some protection against melt-ups. If you look at the pay-off at expiry, you are protected if Europe gets its act together or if the domestic situation improves. With break-evens at 5,118 on the downside and 5,581 on the up, a move outside of any one of these goalposts will make you money.
Whatever your strategy is, volatility seems too low at this point. So make sure you put some “reversion to the mean” trade on.
Bollinger Bands is one of the most widely used volatility indicators. The band is developed by John Bollinger and as the name suggests these are bands (ranges) above and below the price movements. The bands widen when the volatility increases and narrow when volatility decreases. They can be used to identify M tops and W bottoms or to determine the strength of the underlying trend.
The band uses 20 day SMA’s for the calculation of the middle band and for the upper and lower band, SMA plus or minus 2 standard deviations of the past 20 days prices. A simple moving average is used because the standard deviation formula also uses a simple moving average. 95% of the price data should fall between the two bands. The prices are considered to be overextended on the upside (overbought) when they touch the upper band. They are considered to be overextended on the downside (oversold) when they touch the lower band.
Arthur Merrill developed 16 patterns with a basic W shape. A W bottom forms in a downward and involves two reaction lows. In particular you should look for W bottoms where the second low is lower than the first, but holds above the lower band. There are a four steps to confirm a W bottom with Bollinger bands.
According to Bollinger, tops are usually more complicated and drawn out than bottoms. M top is very similar to a double top, though the highs might not always be equal. The second high can be lower or higher than the first high, but Bollinger suggests looking for a sign of non-confirmation when a security is making new highs. A non confirmation occurs with three steps:
The inability of 2nd set of price to reach the upper band shows waning movement, which can foreshadow a trend reversal. Final confirmation comes with a support break or bearish indicator signal.
Moves above or below are not signals per se, but rather act as tags. A move to the upper band shows strength while a move towards the lower band shows weakness. According to the momentum oscillators overbought and oversold signals do not necessarily provide a bullish or bearish signal. Hence the prices can actually walk the band with numerous touches during a strong uptrend and not face the trend reversals.
During this period, prices won’t close above upper band if in a downtrend or won’t close below the lower band if in an uptrend. Such a pattern of the prices staying within the bands (in sync with the underlying trend is called walking the trend.
Let us now look at an example of the above 3 signals and understand how it looks like when it is happening.
In the above chart you can see how we have the W bottoms and the M tops at work. With the top you can see the pullback move (the 3rd spike) and how it was unable to cross the last high and also the upper band.
In the above chart you can see how in the walking the bands for the underlying uptrend the prices are not able to close past the lower band, and hence they keep under the band all this time. 
In your trades, Bollinger bands can be of great help in understanding the price moves. According to Bollinger, the prices for 89 – 90% of the time should be within the bands, the rest can act as your cue for next move.
Utilize them to see how volatile the last 20 days have been to make an informed judgment about your scrip.
Bollinger Bands can be used to decide on option trades as well. Narrowing Bollingers indicate that volatility is falling. If the bands have narrowed significantly over their 2-3 month average, it could be time to buy volatility on that stock. Compression of Bollinger Bands is usually signal of a coming volatility surge.
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).
Caveat: it depends on how much you pay to put on the trade. If increasing volatility is “priced-in”, then the trade may not be profitable even if the target volatility level is reached, as the following pay-off diagram illustrates.
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:
Understanding what volatility is and isn’t is key to understand options. You can refer back to this series using the “volatility” shortcode: http://stockviz.biz/go/volatility We will be discussing options next. Stay tuned!
