Volatility is inherent in markets. An active trader has to learn how to deal with it. If you ask a typical trader what volatility is, he is most likely to say, “it’s the up-down movement of the market.” Well, it’s not just that. Volatility, as measured by the standard deviation of daily returns of the index (or stocks), represents the riskiness of the market. If volatility is increasing, it means the market swings are getting wilder and hence riskier.

When volatility increases, along with the risk, the opportunity to profit also increases. To profit from volatility, one has to correctly predict where volatility is headed. To do that, one can track the India VIX index and compare it with the historical levels. Also, bear in mind that whenever there are important market events, such as budget, election, corporate result announcements or RBI monetary policy meet, volatility increases.

The best way to profit from the variation in volatility is by employing option strategies. The best part of option-based volatility strategies is that you need not be right about the market direction; the market can head either way, and it won’t matter.

Option premiums The underlying premise is that the option premium increases when volatility increases. This is because when volatility increases, the probability of the option expiring in the money also increases. Conversely, when volatility is expected to reduce, the option premiums are also likely to fall. Based on your view on volatility and the time to expiry, here are a few option strategies that you can follow.

When you expect volatility to increase, it means that the option premiums are going to increase as well. Hence, one needs to be an options buyer. If there are more than 15 days to expiry from your trade date, then build a strangle strategy by employing one OTM (out of the money) call option and one OTM put option. If the days to expiry are less than 15, thenbuild a straddle by employing one ATM (at the money) call and one ATM put option. This will help you benefit from the increasing premiums.

When you expect the volatility to decrease, it means that the option premiums are going to decrease as well. Hence, one needs to be an option seller. Sell naked deep OTM options if there are more than 15 days to expiry from your trade date; else, sell OTM options that are slightly away from the ATM mark. In fact, when there are less than 15 days to expiry and volatility is likely to reduce you can benefit in two ways — time decay and drop in volatility. Do remember selling ATM options can be a little risky; hence, it’s best to avoid it.

Also, in the backdrop of an important market event, volatility would shoot up as the event approaches and drop after the event unfolds.

Now in a situation like this, the market will move based on the outcome of the event; hence, selling naked options can be risky. Therefore, one can sell a straddle and benefit from the falling option prices.

So, next time you have a view on volatility, do not just blindly speculate on the market direction.Instead, employ an option strategy.

The writer is Vice President, Zerodha

Related Topics