How Do You Trade Volatility? What You Need to Know
How do you trade volatility? More and more people want to know the answer to that question. The stock market is a volatile place. It’s experienced big drops due to events such as the dot-com bubble, the housing market crisis, and, most recently, the coronavirus. And that scares a lot of investors. But it shouldn’t worry you. Here we’ll go over some ways you can trade volatility.
What Is Volatility?
Price volatility is the change in a security or market’s price over a given time period. The more a price or index moves, the higher the volatility. And the higher the volatility, the higher the risk.
Volatility trading is the buying and selling of securities based on their expected volatility. Rather than focusing on if the price is moving up or down, volatility traders are concerned about how much movement in either direction there will be.
But before we can get into how to trade volatility, you should understand the basics of how to measure it.
How Do You Measure Volatility?
Many investors turn to the CBOE Volatility Index (VIX). It can tell you how willing people are to buy or sell the S&P 500. It focuses on price volatility in the options market. More options trading usually means greater uncertainty.
But there is a mathematical way for investors to measure volatility. The most common method used to measure volatility is standard deviation and variance. This shows how far from the average the price moves. To calculate this, you need the historical pricing action over a given period of time. This could be weeks, months or even years. Next, take all of the stock’s closing prices for that time period. Then, follow these steps.
- Find the mean (average) of the data set.
- Calculate the distance between each value and the mean.
- Square these deviations to get rid of negatives.
- Find the sum of the squared deviations.
- Divide the sum by the number of values minus one in the data set to find the variance.
- Find the square root of the variance.
After completing these steps, the final number is the standard deviation. This tells you how spread-out the data is. Assuming normal distribution, about 68% of data is within one standard deviation and about 95% is within two standard deviations. The standard deviation method can give traders insight into how much the price will fluctuate.
Now that you understand what volatility is and how to measure it, let’s look at how to trade volatility.
How Do You Trade Volatility? Five Strategies
A trailing stop is a type of stop loss order. It’s set to a certain percentage below the market price. As the asset’s price increases, so does the stop price. However, the stop price doesn’t move when the price drops. So a trailing stop loss can help limit losses and also lock in gains. But it’s not always a guaranteed win.
If the stock price hits your stop loss limit, it can automatically enter a trade to exit the position. And if the price tanks well below the limit price, the shares will sell for whatever the market price is after being triggered. And that could lead to lower gains or bigger losses.
Options are contracts giving an investor the right to buy or sell at a predetermined price (called the strike price) by a certain date. Typically, one option contract controls 100 shares. This means the contract’s total price is the option price multiplied by 100. So if a contract is worth $5, it would cost $500. But how do you trade volatility with options?
There are two types of options. The first is a call. A call option lets you buy the underlying asset. For example, suppose a company’s stock is worth $50. You think it will go up, so you purchase a call option to buy at $55. Then, at any time up until the option’s expiration, you can purchase the shares for $55. So if the stock then goes up enough in the open market, you can profit on the trade.
The other option is a put. Put options let you sell. So if you think the company’s $50 shares will go down, you can buy a put option to sell at $45. If shares fall low enough, you’ll profit on the trade. Also, both option types can expire worthless. That’s known as an out-of-the-money option.
You can also sell options. When you sell, you receive the premium, which is the amount paid for the contract. But selling options can carry more risk.
Straddles and Strangles
In these volatility trading strategies, you use more than one option position. There are two main methods: the straddle and the strangle.
In a straddle, you can buy a call and a put option for the same strike price and with the same expiration date. The goal of a straddle is to see the underlying asset’s price change more than the total premium you pay. If price volatility is higher than what was implied in the premiums, you can walk away with a profit.
In a strangle, you can buy a call and put option for different strike prices and with the same expiration date. Usually, the total premium isn’t as much upfront as a straddle, but for a positive return, you’ll need to see bigger price swings.
Another way to trade volatility with options is what’s known as ratio writing. This usually uses a 2-to-1 ratio for options sold to bought. You sell two options for every option you buy. The idea is to offset the risk you’re taking by bringing in more premiums.
You can trade options on the VIX. But you can also trade exchange-traded funds (ETFs). Some of these include…
- iPath Series B S&P 500 VIX Short-Term Futures ETN (NYSE: VXX)
- iPath Series B S&P 500 VIX Mid-Term Futures ETN (NYSE: VXZ)
- iPath S&P 500 Dynamic VIX ETN (NYSE: XVZ)
- ProShares Ultra VIX Short-Term Futures ETF (NYSE: UVXY)
- ProShares VIX Mid-Term Futures ETF (NYSE: VIXM).
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How do you trade volatility? There are many ways, and all of them come with their own risks. But you shouldn’t be scared of volatility in the stock market. Now you know how to trade volatility and, hopefully, profit!