Volatility is one of the most major topics of discussion in the financial markets. Even if you don’t trade it yourself, you’ve probably heard of the concept, and you’ve probably heard it discussed at least once.
Understanding volatility and how to trade it will help you get started if you’re new to trading volatility strategies. In this post, we’ll discuss volatility, how to trade it, and the VIX.
What is Volatility?
Volatility is a measurement of the rate of fluctuations in the value of the price of a security over a period of time. Volatility also indicates the risks associated with an increase in the price of the security.
Traders and investors are interested in calculating the volatility of a security to analyze past price variations and predict the future price movement. Volatility is either determined by Beta or standard deviation.
The dispersion in the price of the security is measured by standard deviation, whereas Beta determines the volatility of a security relative to that of the overall market. Beta is calculated through regression analysis.
Types of Volatility?
Historical Volatility
Historical volatility measures the price of securities in the past and is used to determine future price movements. However, it is not insightful and does not provide direction of the price of trend.
Implied Volatility
Implied volatility is the volatility of an underlying asset, which will return the theoretical value of an option to its current price in the market. Thus, implied volatility is a key element in option pricing and provides a forward-looking approach for future price changes.
How to Calculate Volatility?
The easiest way of calculating the volatility of a security is through standard deviation. The calculation can be done by following these steps:
- Gather all the past prices of securities
- Calculate the average price (mean) of the past prices
- Determine the difference between each price value in the set and the price average
- Square the differences
- Sum the squared values
- Divide the squared values by the total number of prices in the set
- Calculate the square root of the value obtained in the previous step
Volatility Trading
Trading VIX futures has been extremely popular in recent years, and most traders do volatility trading by using iPath S&P 500 and VIX short-term futures ETN, which are exchange-traded products.
Formally, the VelocityShares daily inverse VIX short-term ETN was also used by traders but was shut down by Credit Suisse, the issuer, after a major collapse of value, in March 2018. The trading volume in these exchange-traded products was predicted to be a billion dollars daily.
How to Trade Volatility Index?
When it comes to trading realized market and implied volatility, there are several types of approaches. The main approach is using exchange-traded instruments, such as exchange-traded notes (ENTs) and VIX futures contracts.
When traders are following the approach mentioned above, they are either buying or selling VIX index futures. However, it also depends on their volatility expectations. Some traders use actual VIX futures, but more commonly, traders use ETN, as it mimics VIX future strategies.
Another way trading volatility is through Delta-neutral strategies and S&P 500 options. These approaches are appropriate for active traders and those that are skilled enough to evaluate derivative instruments and trade in exchanges such as CBOE (Chicago Board of Options and Equities).
Motivation for Long Position
Investors can seek help from VXX, SXVY, and VIX futures contracts to protect themselves from market volatility bursts resulting from market instability. Volatility has a strong and, at the same time, negative relationship with the market, especially when it comes to implied volatility. As a result, investors usually have a long volatility position to avoid the risks of market decline.
Motivation for Short Position
This position has been traditionally known as ‘Positive Alpha .’ This is because it holds a long position in the S&P 500 indexes for most parts of the year. In addition, this Alpha position has a positive outcome for traders because usually, VIX futures indexes have a higher price than the current (spot) VIX index value.
The longer the duration of the future, the higher the price will be. Contangó is a situation that occurs in some futures in commodities such as crude oil, and it is a manifestation of the cost of carrying commodities.
Dollar Volume trends indicate Investors’ confidence and fear.
The more comfortable the investors are with the market conditions, the more willing they are to generate profits through VIX futures.
CBOE Volatility Index
The CBOE (Chicago Board of Options Exchange) was created as an indicator that helps investors analyze the volatility of a stock. The VIX is an important tool in measuring market volatility and is sometimes called the ‘Fear Index.’
The index also helps investors figure out the level of fear or optimism in the market; if investors are too fearful or optimistic, there will be erratic movements in the market. When the VIX rises, the level of fear in the market increases, and the index is calculated by the CBOE.
To calculate, the CBOE will collect price data for Options from the S&P 500 index. In addition, there is a different CBOE index for international stocks and is called the CBOE EFT ETA index.
How does VIX work?
The VIX index will increase when investors are investing input options, and the index will decrease if the investors start investing in call options. Generally, a rise in market volatility will automatically move the price of options upwards, but if there is less noise in the market and it is calm, the premium on options will fall.
The calmness is a lack of fearfulness, and when market volatility increases, more investors are investing input options. Volatility is a classic representation of the level of fear in the market.
A rising VIX index could be considered a sign of increasing volatility in the S&P index. In contrast, a falling VIX index can signify that the volatility has decreased, leading to a calmer market.
How to Calculate the VIX?
Option prices are included in the VIX index; however, CBOE does not employ an options pricing model. Instead, the CBOE uses a different formula that analyzes the variance of option prices with the expiration date.
The CBOE will choose options from the index; usually, it will be a combination of put strikes and call that is set to expire on successive dates. Then, the CBOE will calculate the influence of each option on the total variance.
Next, The CBOE will calculate the variance for the two expiration dates and interpolate the two variances to obtain the thirty-day variance. The square of the thirty-day variance is the standard deviation. Finally, to get the total value of the VIX, the standard deviation will be multiplied by 100.
The Importance of the VIX
The VIX is important for both investors and traders, as the higher the value of the VIX index, the higher the expectations of fast-moving stocks. A high VIX value means the prices of options are also high; this information is essential for traders. A high VIX value can also predict price movements and is useful for investors.
Ironically, the VIX index only increases once there is a decline in the market and decreases once the market starts moving upwards. Thus, investors can use this information and invest in shares that decreased due to the market decline.
The VIX is often considered bearish, and a rapidly rising VIX is dangerous, and traders should stay away from the market in such conditions.
Normal VIX Value
There is no normal or consistent VIX value; there is a specific range that most traders consider. A value of VIX that is lower than twenty is a sign of a market that is calm. A VIX value that is higher than thirty indicates that the market volatility has risen. However, these numbers can always change.
How to Trade the VIX?
There are no appropriate trading methods for the VIX index, and there is no way you can invest directly in the index. However, there are futures contracts based on the VIX index that traders can purchase. Traders can also purchase options from the index, but that will depend on the type and amount of options they can access.
There are also ETNs (Exchange Trade Notes) based on the VIX index, and if a trader is willing to invest when there is high market volatility, he could invest in an ETN, and the return will be reflected on the VIX index.
What is an Option?
Generally, options are of two types: a put and a call. It is important to understand the difference between options, allowing you to use them better. When someone buys an option, they have to pay a premium to the seller. Although this is not considered an obligation, this payment will give the buyer the right to buy or sell the underlying assets.
Similarly, there are two major components for options trading: a buyer and a seller. Traders willing to bear the risk sell a significant amount of options, and they collect a premium on it. However, the traders’ premium is considered a liability in most cases unless the options either expire or are bought back.
Call Options
Call options allow the buyer to have the right to buy an underlying asset at a certain strike price and within a specific time. The seller must deliver a long position in underlying contracts in the future if the buyer decides to exercise the call option. If the call option expires, the seller will be forced to take a short position in the market.
Put Options
Put options allow the buyer the right to sell underlying assets at a certain strike price within a specific time. If the buyer chooses to exercise the option, the seller must deliver a short position from the strike price.
Futures Contract
A futures contract is when two parties sign an agreement to buy or sell an asset at a specific price on a future date. For example, one party agrees to purchase an asset on a specific date, while the second party agrees to sell the asset on the date decided. The two parties already agree upon the price of the asset.
Usually, these agreements take place over standard commodities such as:
- Bonds
- Oil
- Gold
- Wheat
- Price of a stock index
The futures agreement is always made on commodities that are regulated. However, one thing that is important to keep in mind is that some commodities (oil, gold, wheat) can be delivered, whereas other commodities (index futures) can be converted into cash.
Typical Users of the Futures Market
- Most participants in the Futures market are either consumers or producers of institutional or commercial commodities.
- Most participants in the futures market are usually Hedges, who trade futures to increase the value of their assets and reduce their losses caused by changes in price.
- Some participants in the futures market are speculators, who profit from the changes in the price of futures contracts.
Regulations in the Futures Market
- Individuals and companies giving trading advice and handling customer funds must register with the NFA (National Futures Association), a regulatory organization that CFTC approved.
- The CFTC gives customers protection by requiring:
- Past performance and market risks need to be disclosed by the customers
- Customer funds must be in a separate account rather than the company’s account
- Accounts of the customer must be adjusted to reflect trading day market value
- The CFTC also monitors: internal controls, registrant supervision systems, and sales practice compliance programs
- The NFA gives details to all the traders; visit their website for more information
Differences between Futures and Options
Futures and Options are derivatives and have several applications such as arbitrage, hedging, and trading. However, options might also be considered portfolio insurance, and traders usually write options against stock positions that they are uncertain about.
Traders also invest in options to hedge against the downturns in the markets. But, on the other hand, Futures are there to allow vendors, producers, and consumers to hedge the inventory and productions by locking in the current price in the market, but only if it is profitable for them.
How Much does it Cost to Trade Futures?
The commission for futures trading can vary. For example, on some commodities, the commission is only $1, whereas, on other commodities, the commission can be as high as $ 10% per contract, especially when trading Bitcoin Futures.
Apart from commissions, there are other costs; some brokers will charge an additional monthly market data and trading platform fee. In addition, each broker requires a specific deposit from traders to trade Futures contracts. Usually, the minimum deposit is $ 1000.
How to Calculate Margin in Futures Trading?
To meet the margins requirement, traders must ensure sufficient capital in their trading accounts before their position opens up. The requirement of margins is usually a percentage of the underlying value under each contract.
For example, if a trader wants to speculate an increase in the March 2021 wheat contract price, he will need to open a buy-to-open account. The specifications of the contract state that a contract controls over 5,000 bushels of wheat (136 metric tons), each bushel as of January 2021 costs $ 6.53.
Conclusion
In this article, we took a deep dive into volatility indexes and how they work. We also emphasized the ways traders and investors use and their approaches to trade in markets with high volatility.
However, volatility as a concept is largely unknown or ignored by traders, which is probably why most traders fail. However, even if you know all the details about volatility, it still does not guarantee anything, as risks are high.
Towards the end of the article, we have shared essential information about Options and futures since they are both part of Volatility indexes and trading. Unfortunately, volatility indexes are complex, and their value only rises once the market declines, and there is no direct way to invest in them.
Read all the information that has been shared in this article, do your analysis, and come up with a bulletproof approach.