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Price swings in the markets can be abrupt and unanticipated, either up or down. These swings are referred to as a “volatile market” and can occur over a period of days, weeks, or months. Expect volatility from time to time, but keep in mind that these are usually transitory stages in the markets. In fact, a market collapse might give investors a terrific deal on individual investments that have experienced a brief decrease.

While the term “volatility” applies to both up and down market movements, investors tend to be more concerned about volatility to the downside. A slide of 10% or more in a major market index (Dow Jones Industrial Average, S&P 500, NASDAQ Composite) is considered a “.” A decline of 20% or more is considered a “” (an increase of 20% or more after a bear market is known as a “bull market”).

While market volatility can happen suddenly, with little warning, it rarely occurs for no reason. Causes of a volatile environment vary but can include: 

  • Surprising economic news that differs from the expectations of investors (e.g., an unexpectedly high result for the Consumer Price Index measuring inflation).
  • A sudden change in monetary policy, such as the Federal Reserve announcing plans to raise short-term interest rates. 
  • Political developments including unexpected election results, an event such as a government shutdown or passage of key legislation designed to give the economy a boost.
  • Geopolitical events such as an outbreak of a military conflict or flaring tensions between powerful nations could have economic ramifications. For example, the Dow Jones Industrial Average crossed into bear market territory shortly after Russia invaded Ukraine in 2022. 
  • Events specific to markets, such as stocks becoming overvalued. This occurred in 2000 when a number of overpriced “dot-com” stocks faced a sudden and dramatic selloff as investors became concerned that prices had outdistanced underlying company fundamentals.

Financial Regulation in Volatile Markets

The recent financial crisis demonstrated the serious consequences of excessive speculative trading on the actual economy. In response, authorities around the world advocated measures to reduce financial market volatility, enhance the actual economy, and improve the welfare of the average citizen. Among these were the Tobin financial transaction tax, short-selling restrictions, and leverage restrictions.

According to Joseph Stiglitz in 1989, “The kind of trade that a turnover tax would discourage is based on the mistaken belief of (all!) speculators that they could do better than average.” However, such proposals have provoked heated debate about whether they have the ability to help or harm markets.

Selling short

Short selling, the sale of borrowed stock that is bought back when it falls for the seller’s profit, has been blamed for causing market volatility by speculators. Regulators have suggested constraints on short selling to reduce the chance of market crashes.

A short-sale ban increases a desire for precautionary savings and limits risk sharing. We found that this constraint only partially restricts speculative trading yet makes investors’ consumption growth more volatile.

Short-sale bans were used in 2008 to prevent financial service companies and banks from failing; but, SEC Chairman Christopher Cox said “The costs [of short-selling bans on financial assets] appear to outweigh the benefits.”

Borrowing constraints

Borrowing/leverage constraints limit the amount one can borrow and invest. For example, banks are limited in the amount of leverage they can take on to reduce their bankruptcy risk. In a research, they investigate the effect of limiting the amount investors can borrow.

Read Also: Why is it Important to Have an Individual Investment?

If you want to stop investors from speculating too much, a simple way is to basically reduce their access to money. When shutting this borrowing down, they found a reduction of the negative effects of speculation. Limiting borrowing is beneficial in our model.

Taxing transactions

Another restraint is the financial transactions tax. They found that a smaller (0.25 percent) tax improves investors’ welfare less than half of the time. But, for transaction taxes between 0.5 percent and one percent, it is very likely that a neutral or even positive effect occurs.

The financial transaction tax is effective because the risk is shared continuously in small amounts. The FTT, for small or occasional traders, is negligible. But those investors who speculate often, with huge amounts, are impacted severely by the FTT. 

An essential question is the way central banks and governments view the role of financial markets – how much is risk sharing and speculation? In considering regulations, the first thing to establish is what fraction of trade is risk sharing and what fraction is speculation; these fractions may change, depending on the condition of the market (crisis or normal times).

What is The Best Strategy For Volatility?

It’s natural to be concerned about your money in tumultuous markets. This is entirely normal. However, market volatility is totally natural and to be expected. In fact, whether you invest in a single fund, manage your own investments, or have them managed by a professional investment manager, present market conditions may potentially work in your favor.

The price of an option is determined by seven factors. Six have known values, and their input values in an option pricing model are clear. The seventh variable, volatility, is merely an estimate, but it is the most crucial aspect in deciding an option’s price.

Traders can use a variety of tactics to profit on volatility. The basic tactics for trading volatility are listed below.

The seven factors that determine the price of an option are as follows. Note that volatility is the only factor that is unknown, which allows traders to bet on the movement of volatility.

  • The current price of the underlying – known
  • Strike price – known
  • Type of option (Call or Put) – known
  • Time to the expiration of the option – known
  • Risk-free interest rate – known
  • Dividends on the underlying – known
  • Volatility – unknown

Historical vs. Implied Volatility

Volatility can be historical or implied, expressed on an annualized basis in percentage terms. Historical volatility (HV) is the actual volatility demonstrated by the underlying asset over some time, such as the past month or year. Implied volatility (IV) is the level of volatility of the underlying implied by the current option price.

Implied volatility is more relevant than historical volatility for options’ pricing because it looks forward. While historical and implied volatility for a specific stock or asset differs, historical volatility can be a determinant of implied volatility.

An elevated level of implied volatility will result in a higher option price, and a depressed level of implied volatility will result in a lower option price. Volatility typically spikes around the time a company reports earnings. Thus, the implied volatility priced in by traders for this company’s options around “earnings season” will generally be significantly higher than volatility estimates during calmer times.

Volatility and Vega

The “Option Greek” that measures an option’s price sensitivity to implied volatility is known as Vega. Vega expresses the price change of an option for every 1% change in volatility of the underlying asset.

  • Relative volatility refers to the volatility of the stock at present compared to its volatility over some time. Suppose stock A’s at-the-money options expiring in one month have generally had an implied volatility of 10%, but are now showing an IV of 20%, while stock B’s one-month at-the-money options have historically had an IV of 30%, which has now risen to 35%. On a relative basis, although stock B has greater absolute volatility, it is apparent that A has had a bigger change in relative volatility.
  • The overall level of volatility in the broad market is also an important consideration when evaluating an individual stock’s volatility. The best-known measure of market volatility is the Cboe Volatility Index (VIX), which measures the volatility of the S&P 500. Also known as the fear gauge, when the S&P 500 suffers a substantial decline, the VIX rises sharply; conversely, when the S&P 500 is ascending smoothly, the VIX will be becalmed.1

Option traders typically sell, or write, options when implied volatility is high because this is akin to selling or “going short” on volatility. Likewise, when implied volatility is low, options traders will buy options or “go long” on volatility.

  • 1. Go Long Puts

When volatility is high, traders who are bearish on the stock may buy puts based on the twin premises of “buy high, sell higher,” and “the trend is your friend.”

For example, Company A closed at $91.15 on Jan. 27th. Traders bearish on the stock could buy a $90 put, or strike price of $90 on the stock expiring in June. The implied volatility of this put was 53% on Jan. 29th, and it was offered at $11.40. Company A would have had to decline by $12.55 or 14% from those starting levels before the put position is profitable.

Traders who want to reduce the cost of their long put position can either buy a further out-of-the-money (OTM) put or defray the cost of the long put position by adding a short put position at a lower price, a strategy known as a bear put spread. A trader could have bought a June $80 put at $7.15, which was $4.25 or 37% cheaper than the $90 put at the time, or chosen a bear put spread by buying the $90 put at $11.40 and selling (writing) the $80 put at $6.75. The bid-ask for the June $80 put was thus $6.75 / $7.15, for a net cost of $4.65.

  • 2. Short Calls

A trader who is bearish on the stock but hoping the level of implied volatility for the June options could recede might have considered writing naked calls on Company A for a premium of over $12. Assume that the June $90 calls had a bid-ask of $12.35/$12.80 on Jan. 29th, so writing these calls would result in the trader receiving a premium of $12.35 or receiving the bid price.

If the stock closed at or below $90 by the June 17 expiration of those calls, the trader would have kept the full amount of the premium received. If the stock closed at $95 just before expiration, the $90 calls would have been worth $5, so the trader’s net gain would still be $7.35 ($12.35 – $5). Assume the Vega on the June $90 calls was 0.2216. If the IV of 54% dropped sharply to 40% (14 vols) soon after the short call position was initiated, the option price would have declined by about $3.10 (14 x 0.2216).

Writing or shorting a naked call is a risky strategy, because of the unlimited risk if the underlying stock or asset surges in price. What if Company A soared to $150 before the June expiration of the $90 naked call position? In that case, the $90 call would have been worth at least $60, and the trader would be looking at a large 385% loss. To mitigate this risk, traders often combine the short call position with a long call position at a higher price in a strategy known as a bear call spread.

  • 3. Short Straddles or Strangles

In a straddle, the trader writes or sells a call and a put at the same strike price to receive the premiums on both the short-call and short-put positions. The trader expects IV to abate significantly by option expiry, allowing most of the premium received on the short put and short call positions to be retained.

For Company A, writing the June $90 call and writing the June $90 put would have resulted in the trader receiving an option premium of $12.35 + $11.10 = $23.45. The trader anticipated the stock staying close to the $90 strike price by the time of option expiration in June.

Writing a short put requires the trader to buy the underlying at the strike price even if it plunges to zero while writing a short call has unlimited risk. However, the trader has some margin of safety based on the level of the premium received.

If the underlying Company A stock closed above $66.55 (strike price of $90 – premium received of $23.45) or below $113.45 ($90 + $23.45) by option expiry in June, the strategy would have been profitable. The exact level of profitability depends on where the stock price was by option expiry; profitability was maximized at a stock price by expiration of $90 and reduced as the stock gets further away from the $90 level.

If the stock closed below $66.55 or above $113.45 by option expiry, the strategy would have been unprofitable. Thus, $66.55 and $113.45 were the two break-even points for this short straddle strategy.

A short strangle is similar to a short straddle, but the strike price on the short put and short call positions are not the same. The call strike is above the put strike, and both are out-of-the-money and approximately equidistant from the current price of the underlying.

With Company A trading at $91.15, the trader could have written a June $80 put at $6.75 and a June $100 call at $8.20, to receive a net premium of $14.95 ($6.75 + $8.20). In return for receiving a lower level of premium, the risk of this strategy was mitigated because the break-even points for the strategy became $65.05 ($80 – $14.95) and $114.95 ($100 + $14.95). 

Five strategies are used by traders to capitalize on stocks or securities that exhibit high volatility. Most of these strategies involve unlimited losses and can be complicated. They should only be used by expert options traders who are well-versed in the risks of options trading.

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