Volatility Strategies: Profiting From Market Fluctuations In The City

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Volatility Strategies: Profiting From Market Fluctuations In The City

Volatility Strategies: Profiting From Market Fluctuations In The City

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What Is Volatility?

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Market volatility describes the magnitude and frequency of changes in stock market pricing and is most often used by investors to measure risk by helping to predict future price changes.

Volatility is the frequency and magnitude of changes in the market pricing of an asset (or collection of assets).

Market volatility measures the frequency and magnitude of asset price changes, i.e. the magnitude and amount of “swing-like” fluctuations.

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Volatility is associated with all asset values ​​in the stock market and is an important part of investing.

In the context of the stock market, volatility means the fluctuation of a company’s share price (i.e. share issues) in the open market.

If a company’s stock price has historically experienced dramatic price swings frequently, the stock is considered to be volatile.

Volatility Strategies: Profiting From Market Fluctuations In The City

Conversely, if a company’s stock price has remained stable with minimal deviation over time, the stock has low volatility, meaning the stock’s value does not fluctuate significantly or change frequently.

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The price of an asset is a function of market supply and demand, so the root cause of volatility is investor uncertainty.

In other words, for volatile stocks, sellers are not sure where to set the Ask Price, and buyers are not sure what a reasonable bid price would be.

In addition, factors such as seasonality, cyclicality, market speculation and unexpected events can contribute to market uncertainty.

Investing is about balancing risk and return, so you can’t have big profits without the possibility of experiencing significant losses.

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If a company’s stock price is constantly fluctuating, selling the investment for a profit (i.e., a capital gain) requires “market timing” and avoiding adverse changes in direction.

Otherwise, the investor may have to hold the investment longer, making the stock a less attractive option.

In fact, investors demand a higher rate of return to compensate for the higher uncertainty, i.e. the higher cost of equity capital.

Volatility Strategies: Profiting From Market Fluctuations In The City

In practice, implied volatility (IV) carries more weight than historical volatility because it is a forward-looking rather than a backward-looking statistical measure calculated from past price movements.

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In valuation, one common measure of volatility is called “beta (β)” – defined as the sensitivity of a security (or portfolio of securities) to systematic risk relative to the broader market.

Most traders use the S&P 500 as a market proxy to compare stock price data for a particular company.

Beta describes the correlation between the price of a particular stock and the S&P 500 (“the market”), which is interpreted according to the following guidelines.

Uncertainty increases volatility, and the prevailing market sentiment is reflected in the prices of speculative financial instruments.

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Since then, the VIX is one of the most widely used measures of market volatility and investor sentiment among market participants such as traders and investors.

The VIX estimates the implied volatility of the S&P by looking at the prices of underlying stock options tracked over a 30-day period, which is then annualized to determine a formal forecast.

Implied volatility attempts to quantify the volatility expectations of options traders (i.e. put and call options) – hence the VIX is often referred to as a “fear index”.

Volatility Strategies: Profiting From Market Fluctuations In The City

Often, if the VIX is high, stock prices in the market fall and investors allocate more of their capital to fixed-income securities (eg, government bonds, corporate bonds) and “safe havens” such as gold.

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For example, the effects of the COVID pandemic in early 2020 (ie the sudden spike) can be clearly seen in the VIX chart below.

For example, implied volatility increases significantly before a company’s earnings report (i.e., options activity and variance), especially for fast-growing stocks.

Implied volatility can be derived by looking at option pricing according to the general rules of thumb listed below:

Volatility in itself is not a negative sign for investors, but investors still need to understand that the possibility of outsized returns comes with significant losses.

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Volatility Strategies: Profiting From Market Fluctuations In The City

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. Optiontrading strategies allow traders and investors to profit in ways that are not available to those who only buy or sell the underlying security. One such strategy is known as a “calendar spread, sometimes called a ‘time spread.'” When a calendar spread is entered using near-the-money or at-the-money options, the calendar spread allows traders to profit if the underlying security remains relatively unchanged for a period of time. also as a “neutral” strategy.

Volatility From The Investor’s Point Of View

When taking a calendar spread, it is important to consider the current and future projected level of implied volatility. Before we discuss the impact of changes in implied volatility on the calendar spread, let’s first look at how the calendar spread works and what exactly implied volatility is.

Making a calendar gap simply requires buying a call or put option for the expiring month, which is also at the same time selling a put or put option for the closer to expiration month. In other words, the trader would sell an option maturing in February and simultaneously buy an option maturing in March-April or some other future month. This trade typically makes money based on the fact that the value of the option sold is higher than the option bought, which means it will experience the passage of time much faster than the option bought.

However, there is another factor that can profoundly affect this trade, and it has to do with the Greek variable vega, which indicates how much value an option gains or loses due to a 1% increase in volatility. A longer-term option always has a higher Vega than a shorter-term option with the same strike price. As a result, the price of the purchased option varies more with the calendar difference as a result of changes in volatility. This can have profound effects on the spread of the calendar. In Figure 1, we see the risk curves for a typical “neutral” calendar spread, which generates money as long as the underlying security stays within a certain Price Range.

At the current level of implied volatility (about 36% for the put option and 34% for the call option), the breakeven prices for this example trade are $194 and $229. In other words, as long as the underlying stock is between $194 per share and $229 per share at the expiration of the shorter-term option (and assuming no change in implied volatility), this trade will show a profit. Likewise, the maximum profit potential for this trade is $661 if there were no changes in volatility at all. This will only happen if the stock closes exactly at the strike price of both options at the close of trading on the day the sold option expires.

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Let us now consider the impact of changes in implied volatility levels on this example calendar spread. If volatility levels increase after the trade is made, these risk curves will shift higher – and the profit points will widen – as a result of the price of the option bought rising more than the option sold. This happens as a function of volatility. This phenomenon is sometimes called “volatility congestion”. This effect can be seen in Figure 2, which assumes a 10% increase in implied volatility.

After this higher level of volatility, the breakeven prices are now $185 and $242 and the maximum profit potential is $998. This is solely because the increase in implied volatility caused the price of the longer-term option purchased to rise more than the price of the shorter-term option sold. Because of this, it makes sense to make a calendar difference when the implied volatility of the underlying security’s options is at the bottom of its historical range. This allows the trader to enter the trade at a lower cost and allows for a higher profit if volatility rises later.

At the other end, traders must also be aware of the potential for what is known as a “volatility crush.” This happens when the implied volatility decreases after that

Volatility Strategies: Profiting From Market Fluctuations In The City

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