Posts tagged with: Volatility

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.

 

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Section 1: Historical Volatility


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
  • Mean-reversion
  • 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!

Resources

Karen the Supertrader: series of interviews on TastyTrade

Karen the Supertrader – SEC fraud accusations

New Yorker article on Vic Niederhoffer, from 2007

 

Difference between the VIX and 30-day historical volatility of the S&P 500

 

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.

 

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(Part 6 of ten-part series on Financial Truths)

Section 1: Intro to Options

Section 2: Professionals Sell More Options Than They Buy

Section 3: Sell a Covered Call Against a Long-Term Holding

Section 4: Sell a Naked Option

Section 5: Sell a Spread

Section 6: It’s Got Options, But Should You Really Trade It?

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Section 1: Intro to Options

  • Calls and Puts
  • Options are defined by: Type (call or put), ticker symbol, strike price, and expiration date
  • Intrinsic value vs. time value
  • Constructing a profit graph
  • Long Call

    Long Put

    Short Call

    Short Put

    Long Strangle

  • Certainty vs. Probability: If you can eliminate a certain range of prices from the range of likely outcomes, OR isolate a couple scenarios that are most likely to occur, you can set up a trade with options that captures that hypothesis

Section 2: Professionals Sell More Options Than They Buy

  • Options are a form of leverage
  • Do you want to be the bank or the borrower?
  • Buying time costs money

Section 3: Sell a Covered Call Against a Long-Term Holding

Section 4: Sell a Naked Option

    • Collect premium up-front
    • Hold cash or margin reserves to back the position until expiry
    • It’s possible to lose several times the premium you took in
    • Importance of position management
    • Example:

Section 5: Sell a Spread

  • Same as selling a naked option, except you also buy an option having the same expiration date and a more extreme strike price
  • Position has a net credit (premium in your pocket)
  • Advantages and disadvantages

Section 6: It’s Got Options, But Should You Really Trade It?

  • Bid-ask spread: don’t get ripped off
  • If premiums are very rich, ask why

 

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(Part 2 of ten-part series on Financial Truths)

 

Section 1: What is Volatility?

Section 2: What is Risk?

Section 3: How to Profit from Volatility and Risk

 

 

Section 1: What is Volatility?

  • Volatility: the variation in asset prices or other financial indices over a given time horizon.
    • Changes in stock prices
    • Movements in interest rates, currency exchange rates
  • Some of this volatility is random and unpredictable, but some can be anticipated by savvy investors who are skilled in technical and/or fundamental analysis
    • I believe that as you expand the timeframe, from minute-by-minute to hourly, daily, weekly, and monthly charts, you get less random noise and more predictable trends and patterns
    • Others believe the shortest timeframes are the most predictable
    • Both perspectives are OK!
  • Actual volatility: can be calculated from historical prices
  • Implied volatility: is the volatility for a future period of time, as estimated by market participants
    • As implied volatility increases, the prices of options (calls and puts) increase along with it
    • The Volatility Index (VIX), calculated by the Chicago Board of Exchange, measures the market’s expectation of the 30-day volatility of S&P 500 Index options.  The VIX is commonly quoted in the media
    • Exchange-traded funds that track the VIX, for short-term speculative trades: VXX, XIV

 

Section 2: What is Risk?

  • Risk is a specific type of volatility: the probability of suffering a loss of a certain size
  • Rooted in probability and statistical concepts
    • A wide range of outcomes can happen over a given time period, from large losses to huge profits
    • The simplest illustration is a bell curve: height represents probability, width represents range of possible outcomes (left=bad, right=good).  Two sample curves below:
    • The market doesn’t follow a bell curve in reality, but it’s a simple illustration
  • Risk is defined differently for every investor and trader
    • 1- You choose the amount that represents a significant loss to you (percentage?  dollar amount?)
    • 2- You choose the timeframe over which to measure profit/loss
    • 3- You choose how often you can accept this amount of loss (there is NO WAY to trade with zero chance of a significant loss)
    • What will you do if/when the loss occurs?  This determines how often you can accept that significant loss (1 in 5 years?  1 in 30 years?)
  • Most trading books recommend limiting the risk of each trading position one-by-one.  Simple, but misleading
    • Common rule: set a stop-loss at 1%, 5%, or 10% of your trading capital
    • Far better to understand the risk level of the entire portfolio of investments and trading positions together.  It’s more complex, but our Trade Analytics and Coaching services will assist you
    • Calibrate the risk level of your portfolio so it matches up with your definition of risk, determined by the 3 components of the prior step.  (1-Amount, 2-timeframe, 3-how often)
  • Your personal risk tolerance determines how aggressively you can invest in the markets, and what kinds of financial instruments you can trade.

 

Section 3: How to Profit from Volatility and Risk

  • Most important: Stay within your own risk management plan
    • Keep enough cash reserves OUT of the markets for things like: job loss, adversity, major purchases or down payments
    • Define a maximum loss over a certain time horizon, and know what you’ll do if it’s reached
  • When implied volatility is too high, sell options (calls and/or puts) to put those fat option premiums in your pocket
  • Keep extra dry powder for crises, panics, downturns, buying “fallen angel” stocks & bonds
    • When the market is stricken by fear, but better times are around the corner, you’ll be able to load up on bargains and wait for normal conditions to return
    • Many institutions aren’t allowed to invest in stocks and bonds below a certain size or credit rating, so they’ll be forced to sell
    • As long as you’re within your overall risk management plan, buy from them at “fire sale” prices
    • Example: VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL) vs. oil ETF

 

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