Volatility is such a vital concept, but it’s commonly misunderstood. You can’t trade for a living without knowing volatility inside and out. In this episode, I introduce some powerful strategies to harness volatility for profit, but not before laying out the foundations such as: how to measure historical volatility, the difference between historical and expected future volatility (e.g. the VIX), and the reasons why markets often misprice volatility.
Section 1: Historical Volatility
- Basic concepts
- Embrace volatility, responsibly: that’s how traders make money!
- An easy method to calculate historical volatility, using spreadsheet software and daily price data from Yahoo Finance or Google Finance
- Download a free volatility calculator in Microsoft Excel by signing up for free email news and updates. You will receive a link to download the file immediately upon confirming your email subscription. You can unsubscribe at any time if you wish.
Section 2: Future Volatility
- All about the VIX (the “fear index”) – definition, how it’s traded, limitations
- Factors that impact the market’s expectation of volatility for a stock or an index
- Volatility risk premium
Section 3: Volatility & Options (Calls and Puts)
- Expected volatility across different strike prices and expiration dates
- Impact of volatility on option pricing
- Vega: one of the Greek letters used by options traders
Section 4: Using the VIX as a Portfolio Hedge
- Definition of a hedge
- VIX ETFs or ETNs
- Buying or selling VIX options
- Better methods for hedging your assets against volatility, if that’s your goal
Section 5: How to Trade Volatility Without Going Broke
- Stop trading VIX ETFs and ETNs! Just stop!
- Writing OTM options has been called “picking up nickels in front of a steamroller” by those who don’t know the correct way to do it
- Study the examples of those who failed: Karen the Supertrader, Vic Niederhoffer (see Resources section below)
- Set reasonable goals
- Write close-to-the-money, at-the-money or in-the-money options instead of deep OTM
- Layer fundamental analysis on top of technical analysis
- Multiple layers of technical analysis, such as intermarket analysis to find confirmation or divergence
- No “autopilot”!! – Manage positions carefully throughout their lifespan
- Three simple trading strategies based on volatility
- Complex strategy, but not really so hard to learn: The Options Ladder – stay tuned, more details coming in the future!
Technical note: The 18% historical volatility (to be precise, 18.6%) I cited for the S&P 500 was based on a 252-trading-day lookback period. When I use a 21-trading-day lookback period instead, I get 16.6%. The 21-trading-day lookback period is more appropriate when drawing comparisons against the VIX because the VIX is the implied volatility 30 days (21 trading days) into the future. I used the 21-trading-day lookback period in the chart of volatility risk premium above.
Intro music and mid-program music by audionautix.com