In the current financial climate, profiting from market volatility is an issue to which traders should be paying special attention, given the contextual surroundings that mark the last half-decade. Looking at the chart below, we can see that some of the most turbulent years of the last century have occurred during this time, so the prudent investor will benefit greatly by understanding some of the strategies that are regularly employed when we are looking to benefit from market instability.
The above chart shows that recent volatility, measured by the VIX volatility index, has far surpassed long-term historical averages.
First, we will look at the ways volatility is commonly measured. To do this, we must examine the “option” contract, which is a financial instrument that is given value based on the price of another asset (usually a stock, commodity, or bond). The average change in price (volatility) of that asset is the key determinant in assigning option prices.
For example, purchasing an option on Google is much more expensive than buying an option in a stable real estate market. Google stock has the potential to move 3-5% in a day whereas a similar investment in real estate might fluctuate an average of 0.1% during the same time period. The total cost of the real estate trade is cheaper because prices are less likely to experience a drastic change.
Using these option prices, statisticians can create an accurate and practical gauge for determining market volatility. Furthermore, using long-term trends and historical averages, market participants can make projections about the future volatility of specific assets. The most commonly watched measurement of this activity is the Volatility Index (VIX), which catalogs options prices for the stocks that make up the S & P 500.
CFDs, Options and Futures
Next, we will outline the financial instruments traders use to capitalize on market volatility. A contract for difference (or CFD) is similar to an “option” in that it allows a buyer and seller to bet on the price movements of an underlying asset. When the contract is closed, the seller will pay the buyer the difference between the asset’s current value and the value at contract initiation. Conversely, if this difference is negative, the buyer pays the seller. Many traders prefer this method of settlement because CFDs do not require physical delivery of the underlying security.
Options contracts, as the name suggests, give a buyer the option, but not the obligation to bet on the future price of an asset, within the limitations of a previously defined time frame. Typically, options traders deal with stocks, bonds, currencies or commodities but, in theory, an option could be created for any type of valuable asset. The option to buy is called a “call.” The option to sell is called a “put.” The “strike price” (or exercise price) is the level at which the security can be bought or sold up until the “exercise date,” which is when the option contract closes. The difference between the strike price and the price at the close of contract is the amount of profit or loss in the trade. Maximum losses, however, can never exceed the amount of the original premium paid. Historical volatility of the security, along with current interest rates and time until expiration, determines the cost of the transaction. Greater volatility means higher trading costs.
A futures contract enables speculators to buy or sell an asset at predetermined date and price. Some of these contracts require physical delivery of the asset but most of these transactions are settled in cash. One difference between a futures exchange and those dealing with stock markets is that futures traders often use a high degree of leverage with the intention of maximizing profits. But it must always be remembered that risk works both ways and can also lead to heavy losses. The biggest difference between futures and options is that options give traders the right to make a sale or purchase where futures outline the requirement to fulfill the original contract terms.
Historically Volatile Markets
When dealing with volatility strategies, it is important to remember that all markets are not created equal. As mention previously, real estate is an example of a relatively stable market that, for the most part, experiences moderate gains over long periods of time. Illiquid markets with fewer participants behave in drastically different ways and can experience immense price swings in short periods of time. Most currencies, metals and soft commodities fall into this category. In addition to higher trading costs, investors need to prepare for the wild price swings that this class of assets could potentially experience. If we are trading a futures contract, this means having the flexibility to accept wide stop losses within a framework that obeys sound risk-to-reward management.
Last, we will show an example of a volatility trade using an equity-based CFD. Google stock is currently trading at $590.85 per share ($590.81 bid and $590.89 offered). We will say that our bias is bullish, so we buy 100 shares at the entry price of $590.89. If this was a short position, our entry price would be $590.81. Our total cost for the transaction is $59,085.00 ($590.89 x 100) but we will leverage this position 10:1, making the actual payment $5908.50 (10% margin requirement). Commission costs are 0.1%, paid to the provider and there will be additional financing charges if the position is held overnight.
Let’s assume that the stock price rises 20$, to $610.85, and we choose to close the trade. To calculate the gains, we multiply the number of shares by the exit price (100 x $610.85 = $61085.00) and then subtract the size of the original position ($59,085.00). From this, we subtract the trading costs (0.1% x $61085.00 = $61.08), creating a total gain of $1938.92 for the trade.
In this case, we chose a relatively volatile stock and we placed the trade using leverage. In the example, the returns in percentage terms were excellent but it must be remembered that losses could have been equally large if prices had moved in a direction that was unanticipated. Under these circumstances, it is always important to keep specific risk-management safeguards in place.