Volatility Trading 101: What Beginners Need to Know
Volatility trading is different from other types of trading, yet it can be a profitable form of playing the stock market for those interested in pursuing it. Everyday trading tends to focus on the price of stocks. But volatility trading focuses on just what its name implies – volatility in the markets and in the price of a stock.
When we talk about volatility, we’re talking about the price movement of a stock or of a market. The higher the level of volatility, the more movement in the price. This movement can be in either direction: up or down.
In this article, we will look at what volatility trading is and how you can use it to make money in the markets.
What Is Price Volatility?
Simply put, price volatility is the amount of change in the price of a security or market over a given time period. The more a price or index moves, the higher the volatility.
Volatility implies risk. The more the price of a security moves, the riskier it is. But a certain amount of risk is good for investors… after all, if you invested in a stock and the price never increased, you’d earn no profits from capital gains.
Of course, risk has a downside as well. The more the price of a security moves, the more likely it is that you will lose money on the stock as well.
In financial markets, the more risky a particular security, the higher return you have the potential to earn. But, every investor needs to decide for themselves how much risk they are willing to take on in exchange for that potential to earn a return.
What Is the VIX Volatility Index?
The Chicago Board Options Exchange’s (CBOE) VIX, or the volatility index, is a term that’s been thrown around a lot lately. Many investors use it as a market-timing indicator. But most of us don’t know what it is, how it works or its relationship to volatility trading.
The VIX is a weighted mix of the prices for a blend of S&P 500 Index options, from which implied volatility is derived. Implied volatility is the expected volatility of the underlying security. The VIX concentrates on the price volatility of the options markets, not the volatility of the index itself.
If implied volatility is high, the premium on options will be high. The opposite is also true. Therefore, when investors see options premiums increase, there’s the assumption that we can expect future volatility of the underlying stock index. This represents higher implied volatility levels.
This VIX volatility index is an attempt to quantify fear in the marketplace. It reflects investors’ best predictions of near-term market volatility or risk.
The Rule of Thumb (usually): The VIX goes up when there’s turmoil in the market, and goes down when investors are quite content or at ease with the economic outlook.
VIX Volatility Index Trading
Investors can trade VIX volatility Index options and futures to directly trade the ups and downs of the market. No matter which direction the market goes, you can make profits by trading the market swings.
VIX options and futures are available through the CBOE, the same exchange that created the VIX volatility index. (And incidentally, the place where expert Trade Tactician Bryan Bottarelli used to work.)
Let’s suppose that an investor thinks the market is going to become more volatile. One way to play this is to buy a VIX call option if the investor thinks the market volatility will go up. On the opposite side, if the investor expects a volatility decrease, they can buy a put option.
Generally, the same goes for futures. If you think volatility will increase, you can go long a futures contract. And if you think the opposite, then you can short a futures contract.
Some Volatility Trading Strategies
There are a few different trading strategies you can use when you are trading volatility. Here are two of the available possibilities:
1. The Straddle Strategy
This is a strategy to use when you expect the volatility of a security to increase. You can accomplish this by buying a call option and a put option on the same security. The two options also must have the same maturity date and strike price to work correctly.
2. The Strangle Strategy
This strategy involves using both an “out of the money” call option and an “out of the money” put option. “Out of the money” means that an option has no current intrinsic value. For example, if you have a $5 call option – the right to buy a stock at $5 – but the stock is trading at $4, the option is out of the money. After all, why would you exercise an option to buy a stock at $5 when you could simply buy it for $4 on the free market?
Without getting too much into the weeds, you can use the strangle strategy as a cheaper alternative to a long straddle position. Though it is cheaper than the long straddle, the tradeoff is you need a higher level of volatility to make money.
Concluding Thoughts on Volatility Trading
Volatility trading can be a profitable way to make money in the markets. One advantage is that it doesn’t matter whether or not the market swings up or down. All that matters is that it swings.
If you’re interested in learning more about it, I highly recommend signing up for Bryan Bottarelli’s Trade of the Day e-letter. It’s free and packed full of tips on how to trade both stocks and options.
Volatility trading is definitely not for everyone, but I hope you now have a much clearer sense of what it is, how it works and whether it may be right for you.
About Brian M. Reiser
Brian M. Reiser has a Bachelor of Science degree in Management with a concentration in finance from the School of Management at Binghamton University.
He also holds a B.A. in philosophy from Columbia University and an M.A. in philosophy from the University of South Florida.
His primary interests at Investment U include personal finance, debt, tech stocks and more.