What is Volatility Trading? 5 Strategies to Win Volatility

Introduction

Volatility trading is not a special kind of trading. It is similar to any other trading activity. Here a trader ascertains the current volatility in the market and leverages that as a trading opportunity.

Option traders generally focus on volatility trading mainly because it affects the option price or premium. The higher the volatility, the higher the price of an option and vice-versa. Volatility influences the market mood, risk factors, and uncertainty. It helps a trader select an appropriate strategy to benefit from a higher or lower volatility. In other words, ‘volatility trading’.

What is Volatility?

Volatility is a measure of how much the price of a stock or an index can fluctuate over a specific period. In other words, it shows the degree of uncertainty or risk associated with a stock or index. In the context of options trading, volatility is one of the most critical factors as it has a direct influence on the option premium or price.

A trader cannot do volatility trading without understanding the types of volatility associated with options trading especially implied volatility and historical volatility.

Key Topics for Volatility Trading

Implied Volatility (IV)

Implied Volatility is derived from the current price of options. It also determines the market’s expectation of future volatility. It is dynamic and constantly changing based on market sentiment, uncertainty, demand-supply, and upcoming events of the option.

Historical Volatility (HV)

Historical Volatility is measured based on the actual past price movement of the underlying asset over a certain period. HV shows how volatile the asset has been and provides a baseline figure of HV for future expectations.

Volatility Skew

This is not a type of volatility; it is more of a behaviour of Implied Volatility at a given point of time. Volatility skew refers a particular market situation when there is a difference in implied volatility across various strike prices or expiration dates. Volatility Skew provides a good insight to a trader where to expect the most price movement and demand-supply. This can be a guiding factor for selecting an appropriate strategy.

Volatility skew can be categorized into the following types that can help in volatility trading.

1. Vertical Skew (Strike Price Skew)

Vertical skew refers to the variation in implied volatility across different strike prices for the same expiration date. It helps to identify the risks at different strike price levels (OTM, ATM, and ITM options).

Let’s understand using an example. Assume Nifty 50 is trading at ₹24,000, and the implied volatility for options expiring in the current month is as follows:

Strike Price	Implied Volatility (IV)
₹23,500 (OTM Put)	25%
₹24,000 (ATM)	20%
₹24,500 (OTM Call)	22%

Note: Here, IV is highest at OTM put, followed by OTM call, and lowest for ATM options.

Interpretation: Traders are expecting a higher risk in downside movement (OTM put) compared to upside movement (OTM call). This is a common skew for bear markets or when uncertainty is very high.

2. Horizontal Skew (Expiry Date Skew)

Horizontal skew refers to the variation in implied volatility across different expiration dates for the same strike price. It helps to identify the risk across multiple time frames.

Let’s analyze the strike price ₹24,000 of Nifty 50 across different expiry dates.

Expiration Dates	Implied Volatility (IV)
Current Week	18%
Current Month	22%
Next Month	28%

Note: Here, IV is increasing with longer expiration dates.

Interpretation: Traders are expecting a higher risk or uncertainty on longer-term options. This is why IV is higher. Also, it includes the time value of the option.

Pic Source: https://analystprep.com/

3. Volatility Smile

This is a variation of vertical skew where IV is higher for out-of-the-money (OTM) and in-the-money (ITM) options compared to at-the-money (ATM) options. The shape of which resembles a smiley face, hence the volatility smile.

Let’s take the example of Reliance trading at ₹1280 along with the following IV situation.

Strike Price	Implied Volatility (IV)
₹1240 (ITM Call)	25%
₹1280 (ATM)	20%
₹1320 (OTM Call)	25%

Note: Here, IV is higher in both ITM and OTM strikes of Reliance.

Interpretation: Smile indicates that traders are hedging their position against extreme moves on either side. The potential for the large move is factored into implied volatility.

Pic Source: https://analystprep.com/

Role of IV in Volatility Trading

Options contracts derive their value, not only from the price of the underlying asset but also from the asset’s expected price volatility or IV. Here’s why volatility is so important for options traders.

1. Impact on Option Price:

Higher Volatility always leads to a Higher Price for an option. When volatility is high, options are more expensive because there’s a possibility of huge price swings in the underlying asset. This will in turn lead to a higher probability of the option expiring in the money.

Similarly, Lower Volatility always leads to a Lower Price for an option. When volatility is low, options are cheaper because price movements are expected to be smaller, meaning a lower chance of the option expiring in the money.

For example, a trader is looking at an option on Reliance Industries. If the market expects a significant price movement due to upcoming earnings or events, the implied volatility will rise, and the option price will significantly increase. If the trader buys the option, he will make a profit. On the other hand, if the earnings announcement has already passed and no major events are expected soon, implied volatility will decrease, leading to a drop in the option price.

2. Impact on Probability of Profit:

High Volatility increases the probability that the underlying asset will have a large price movement on either side. This can benefit an option buyer. For example, a high-volatility environment meaning a higher IV, will make it more likely that a long call or long put position will move significantly. So, the option buyer will make a big profit.

Low Volatility decreases the chances of huge price movements. This will help option sellers to profit from strategies that mostly rely on time decay or IV crushes. For example, selling straddles or strangles, where the options expire worthless.

3. Impact on Market Sentiment:

Volatility in general reflects market sentiment. For example, a sudden increase in volatility generally signals a fear factor or uncertainty within market participants. Traders usually consider high volatility as a signal of a potential market correction, upcoming news, and some events that may impact prices significantly.

On the other hand, a low volatility situation is often interpreted as calm or stable market conditions. Here the market expects normal price fluctuations without major disruptions.

4. Influence on Strategy Selection:

Based on the Volatility situation, especially IV a trader can select the appropriate strategy. High Volatility is suitable for strategies that can benefit from large price swings, e.g. long straddles or long strangles.

Low Volatility is conducive to few income-generating strategies like iron condors or short strangle where traders sell options to capitalize on time decay and stable prices.

5. Influence on Risk Management:

Volatility has a direct impact on the risk of any trade. In high-volatility markets, a trader needs to be aware that there is a possibility of rapid price movement, which can lead to quick losses or gains. Traders must adjust their strategies by hedging their positions or reducing position size. In low-volatility situations, risk is generally lower or limited, but traders need to manage their positions to avoid losses due to gradual time decay.

India VIX – The Volatility Index

The Volatility Index (VIX), also referred to as the ‘fear index’ is a real-time market indicator that reflects the market’s expectations of volatility in the short term.

India VIX is a volatility index based on the index option prices of NSE’s benchmark index NIFTY. India VIX uses the computation methodology of CBOE, with suitable amendments to adapt to the NIFTY options order book. India VIX is calculated using the best bid and ask quotes of the out-of-the-money near and mid-month NIFTY option contracts. So, traders engaged in volatility trading must be aware of VIX or India VIX to select an appropriate strategy.

Standard Deviation and Its Role in Volatility Trading

Standard Deviation is a statistical measure that quantifies the dispersion of price movements from the average (mean) price of a particular stock or index. In the stock market, standard deviation is commonly used to measure the volatility of a stock or an index.

Standard deviation is also used to estimate the probability of an asset’s price staying within certain ranges over a given period. It helps traders understand how much the price of a stock or index can deviate from its average price.

In the stock market, price movements usually follow a normal distribution (a bell-shaped curve). Although the market never behaves rationally. However, standard deviation gives a good approximation of the price range using a 1, 2 & 3 standard deviation. Standard deviation provides a probability-based expected price range for traders to predict price ranges and make informed decisions.

• 1 standard deviation: Covers ~68% of expected price movements from mean
• 2 standard deviations: Covers ~95% of expected price movements from mean
• 3 standard deviations: Covers ~99.7% of expected price movements from mean

Let’s understand with an example of Nifty 50. Assume that the current Nifty 50 level is ₹24,000 and the 1-month standard deviation 5% (₹1200)

The expected price range for Nifty 50 within a month is as follows:

• 1 Standard Deviation (68%): ₹22,800 to ₹25,200. This means the Nifty 50 price is likely to stay within this range 68% of the time in a month.
• 2 Standard Deviation (95%): ₹21,600 to ₹26,400. This means the Nifty 50 price is likely to stay within this range 95% of the time in a month.

Best Charting Indicators for Volatility Trading

Charting indicators that measure volatility helps a trader with visual tools to identify periods of high and low volatility. It can predict price movements, and select the appropriate strategies. Below are the best charting indicators to measure volatility.

1. Bollinger Bands:

Bollinger Bands are one of the most popular indicators to measure volatility.

When volatility increases, the bands expand as the standard deviation widens indicating a potential breakout or large price movement.

When volatility decreases, the bands contract as the standard deviation narrows indicating a potential consolidation or range-bound market.

2. Average True Range (ATR):

The Average True Range (ATR) measures the average range between high and low prices over a specified period. This gives the trader a fair idea of how much a stock or index typically moves in a given time.

A rising ATR indicates an increase in volatility, thereby expecting larger price movements. A trader can use ATR to set stop-loss levels based on expected price ranges.

A falling ATR indicates a decrease in volatility, thereby smaller price movements. ATR along with other indicators can be used to confirm strong trends in high-volatility markets.

3. Implied Volatility (IV) Chart:

IV chart plots the implied volatility of an option contract over time, reflecting market expectations of future price movements.

Rising IV indicates increased uncertainty or anticipation of a significant event like earnings report, policy announcement, geopolitical news, etc. A trader can use IV charts to time options buying in low IV and sell optionswhen IV is high.

Falling IV suggests reduced uncertainty and a stable market. Trader can monitor IV changes for specific strikes to identify market sentiment around certain price levels.

4. Historical Volatility (HV) Chart:

Historical Volatility measures the actual price movement of a stock or index over a specific period, calculated using standard deviation. HV charts visually represent how volatility has changed over time.

Spikes in HV indicate sharp price movements in the past. A trader can compare HV with implied volatility (IV) to identify whether an option is underpriced or overpriced.

Falling HV indicates periods of low activity in the past. Traders can use HV trends to identify periods of stable and volatile markets.

Standard Deviation Indicator:

The standard deviation indicator directly measures the dispersion of price movements around the mean, providing a straightforward way to assess volatility.

A high standard deviation means High volatility. Traders can use standard deviation with other trend indicators like moving averages to confirm strong trends or potential reversals.

A low standard deviation means Low volatility. Traders can choose appropriate strategies based on this information.

A Comparison of Volatility Indicators

Top 5 Option Strategies for Volatility Trading

1. Strategy:  Long Straddle

A long straddle is a simple but effective option strategy for making profit from volatility, especially when there is uncertainty on the market’s direction but expect a significant price move. By carefully analysing volatility conditions and market trends, traders can maximize the strategy’s profit. However, it’s essential to enter the trade during low-volatility periods to minimize costs and manage risks effectively.

2. Strategy:  Short Strangle

A short strangle is a high-probability options strategy suitable for range-bound markets with high implied volatility. It allows traders to collect good premiums from both calls and puts options. It generates profit from time decay and reduced IV. However, the strategy comes with higher risks, when the price moves in one direction. This requires careful monitoring and adjustment of the trade for risk management. By understanding the volatility situation and market trends, traders can effectively deploy this strategy to generate consistent income.

3. Strategy:  Credit Spread

Credit spreads are versatile strategies that work best in high IV environments and moderately directional market or range-bound markets. Credit spreads allow traders to collect net premium income with defined risk, making them suitable for cautious directional traders. A trader can use a bull put spread for bullish markets and a bear call spread for a bearish market. Both are net credit strategies. Understanding the volatility situation and market trend is key to maximizing profits with limited risks.

4. Strategy:  Debit Spread

Debit spreads are most suitable for low or moderate-volatility environments and moderate-directional price movements. They are ideal for traders with a clear bullish or bearish outlook. A trader can deploy a bull call spread in a bullish market and a bear put spread in a bearish market. Debit spreads provide a cost-effective and limited-risk strategy to profit from directional moves. Understanding volatility and timing the entry effectively are key to maximizing the profit.

5. Strategy:  Calendar Spread

A calendar spread is a versatile strategy that works best in low-volatility environments where implied volatility is expected to rise and the market trend is neutral to mildly directional. By leveraging time decay and differences in Implied Volatility, traders can profit from range-bound markets and volatility expansions. Properly timed and adjusted, calendar spreads can provide consistent profit.

Conclusion and Key Takeaways

Volatility trading through options is both an art and a science. Using the implied and historical volatility, volatility skew, and market trends, traders can choose a strategy to suit any market environment. Success lies in aligning strategies with volatility conditions and adjusting positions dynamically based on changing market conditions. By employing effective risk management to limit losses and maximize gains.