Warren Buffett once famously said: "Be fearful when others are greedy and greedy when others are fearful."
For most traders, fear and uncertainty are two primary factors that drive market volatility higher and lower.
"Volatility is just another colloquialism for uncertainty,” says JJ Kinahan, chief market strategist at TD Ameritrade. “We don't ‘crash’ up, for instance, so we need a way to talk about the many twists and turns that a market can take, each with its own potential to prompt us to reassess how we trade.”
Just look at the first few weeks of 2016. Massive uncertainty over the state of Chinese economic growth and fears about how low oil might fall roiled global equity markets.
While some investors turn queasy on the roller coaster ride of increased volatility, many active traders embrace volatility because it can sometimes equate to opportunity.
Simply stated, volatile markets often see wide, swinging price moves and heavy trading volume. The level of volatility tends to have an inverse relationship with the direction of stock prices. Generally, as the broader stock market moves up, volatility tends to decrease. In contrast, when the broader market goes down, volatility tends to increase.
Traders often monitor the CBOE Volatility Index (VIX) as an overall "uncertainty" gauge for the broad market. The VIX measures the level of volatility in the S&P 500 (SPX) cash index, and is calculated through the value of out-of-the-money SPX index options.
Kinahan points to an old Wall Street saying: “The market goes up by the stairs and down out the window.” This illustrates the general point that some traders may pay more for protection when the market is going down. That often means that as volatility goes down, options can become more expensive.
3 Ways to Trade Volatility
There are ways for investors and traders to trade volatility. Kinahan explains three methods to get started trading volatility:
1. Scale in and out. Perhaps the most basic avenue to trade volatility is to scale in and out of trades. "As a stock price moves around, consider using it for buys and sells. For example, if you are going to buy 800 shares of a stock, think about buying them iteratively so the average price paid could be lower. Buy 300 and then another 300 and then another 200 at potentially an even lower price," says Kinahan. Keep in mind that this strategy will incur additional transaction costs, including multiple commission charges, which will impact any potential returns.
2. Use VIX options. A second approach to trading volatility is to utilize VIX options. Some options traders who think volatility is going higher might buy a call option because they think the market is going lower; volatility and market direction have an inverse relationship in typical market conditions. On the flip side, those guessing volatility is going lower might buy a put option because they think the market is going higher and volatility could dissipate. That's because if a trader believes that VIX is the broad market's "fear" index, then by most assumptions fear should lessen as the market rallies. (Typically, call options represent the right, but not the obligation, to buy the underlying security at a predetermined price and over a set period of time. Put options represent the right, but not the obligation, to sell the underlying security at a predetermined price over a set period of time. But, remember, VIX options are cash-settled, so there's no underlying security.)
3. Put on a calendar spread. A third approach is to consider expressing a volatility "opinion" in a stock that you are already trading, for instance, with a calendar spread. Using ticker XYZ as an example, an investor might sell February 95 puts and buy April 95 puts. In this case, they would be selling near-term volatility and buying long-term volatility. Long-term volatility tends to have a greater reaction to an increase in volatility in the shorter term.
TD Ameritrade clients can use an options chain on the thinkorswim® platform to help determine potential price moves for an underlying stock. Traders can identify specific stocks that may be on the move. They might start by viewing the individual implied volatility of an option chain. The percentage number on the right-hand side equates to an expected dollar price move in either direction between the day the chain is consulted and option expiration (figure 1).
Parting words? You don't have to fear volatility. "You can go in and say, here is something that can help me," Kinahan concludes.
Probability analysis results from the expected move indicator in the platform are theoretical in nature, not guaranteed, and do not reflect any degree of certainty of an event occurring.