Ever since the budget was presented, it?s been a one-way street at the bourses ? straight down. Losing 700 points on the Nifty in just over a month may not have set the cat amongst the pigeons just yet, but has surely caused jittery nerves. More so when you see 2-3% moves on the Nifty in a day and that too pretty regularly. Such moves strokes volatility ? a necessary evil for the stock markets.
This raises the most debatable question – ?Is volatility good or bad?? Seven out of ten market participants would surely vote against it. Not intending to sound like a crusader of the remaining three, I do believe volatility provides a window of opportunity to pocket a neat return as well as hedge against vagaries of markets. Having said that, trading in volatile markets is akin to surfing the high tides where the participants get extreme rewards for the risk they have undertaken.
Volatility is a measure on how much the price of an asset is expected to move. Theoretically, higher volatility resulted in large directional movements on either side. In the last one year, volatility has risen sharply in two scenarios ? when the Nifty plummeted on one occasion and rose sharply in another, indicating that historical volatility explains the movement rather than the direction. However, implied volatility of call and put options coupled with the accumulation pattern of call and put options will clearly indicate the bias and market direction.
Volatility plays a very crucial role in options trading. The higher the volatility, the richer the option premium; the lower the volatility, the cheaper the premium on the options. For an option buyer, buying options when the volatility is low and selling when the volatility rises makes perfect sense, as he/she can buy these options at a lesser premium. For an option seller, writing options when the volatility is high and buying it back when the volatility declines is the ideal scenario, as he/she can sell at a higher premium.
However, there are instances when options are low priced and volatility is low because market participants did not foresee any major movement in the stock price. In such a scenario, buying options is akin to falling in a pit as the volatility might continue to remain low or may fall further until the expiry of the contract. Similarly, writing options simply because both volatility and premiums are high could prove to be disastrous; options are richly priced because market participants are factoring in a sharp move on either side and volatility could either stay at high levels or increase further, which could be a nightmare for option writers Options hybrid strategies are the most appropriate tools to cash in on the volatility in the markets. The rise or fall in volatility can be captured by designing straddles and strangles.
(The writer is a derivatives analyst)