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Trading high volatility

In today's column we'll address the issue of trading high volatility markets. From the volatility charts seen on our home page you'll notice that just about all stocks go through periods of high volatility. High volatility can range anywhere from 50% to 150% or more depending upon the type of stock that you are trading. Periods of high volatility can appear suddenly and without warning. Therefore, it is best if you know how to trade them or at least know how to protect yourself during those turbulent times.

Depending upon your trading style, high volatility periods can offer you the prospects of large, quick profits. For example, if you are a market-maker or even a day-trader, high volatility periods marked with high trading volume can often make it easier for market-makers to earn numerous bid-ask spreads. For day-traders with a sense of market feel, high volatility can allow them to freely enter the market and trade it equally well from both sides, thus improving their short-term scalping operations. Also, the higher the volatility the greater the tendency there is to widen the bid-ask spread thereby leading to potentially higher gross profits for market makers and scalpers who can read the trade flows or the tape.

High volatility periods offer traders the prospect of unusually large profits if their strategies have been designed with long gamma and vega (volatility) risk in mind. During these periods of rising volatility the long vega/volatility strategies come into their own. It is during these times that market-makers, day-traders and long volatility holders can produce extraordinarily large profits. For traders who have assumed the other side of these unlimited risk trades, high volatility periods can bring great danger and potentially catastrophic losses that can wipe out one's entire capital base within in matter of a few hours or even minutes.

There are two main ways that a long volatility trader can profit when going into a high volatility period. One is from a vega/volatility increase in the implied volatility and the other way is from the delta/gamma profits that result from the wide price fluctuations that occur during these times. In the first case, profits accrue as implied volatility increases. Implied volatility is likely to respond to higher actual stock volatility, especially if the change was unexpected. If a good portion of the market is caught short volatility after the initial price shock you can expect a second run-up in volatility as shorts get squeezed. In instances such as these, the weak (under capitalized) shorts will run quickly and pay just about any price to get out of their losing, unlimited risk positions. On a short squeeze, look for volatility to overshoot all levels as people panic. In the 1987 stock market crash, volatility rose so dramatically that even out-of-the-money long call positions proved profitable as volatility rose to over 150% despite a 500+ point drop in the Dow Jones Industrial Average.

In the case of gamma profits, every rebalance of the delta neutral hedge adds incrementally to the position's profits. In times of high volatility there are normally some very wide swings that can be and should be used for rebalancing purposes. In situations such as these it is better for the trader to be more aggressive than waiting for a particular time of day (closing time or other time period) to rebalance the hedge. A trader should therefore try and take advantage of as many swings as possible--and there will be lots of swings during this period. But knowing when to initiate positions and when to take profits is the essence of gamma trading. In cases such as these it is helpful to have a market feel. If the stock should happen to run strongly in one direction some gamma traders will just let their deltas run. Effectively they have now changed their trading style from one of being a delta-neutral options trader to one of now being a stock price trend-follower. Note that if you can't switch styles or you have no real for the market then it is best to minimize positions as best you can. In conditions such as these you need to be able to make quick decisions and be able to switch and adapt to the environment if you really want to add to your nest egg.

In these times most traders realize that large quick profits can evaporate quickly so they will throttle back the position a bit. But nevertheless, they should be willing to play with other people's money and try to leverage the situation as best as possible once a profit cushion has been created. By leveraging the situation, we mean a trader should try their hand at a gamma trade or let the deltas run on such quick windfalls. In this way, you effectively can have a free trade in which losses can be eliminated quickly or minimized but upside potential can become large enough to make your year. In situations where the market whipsaws frequently market-makers and day-traders who are willing to trade both sides of the market can do quite well. The frequent price reversals can create numerous opportunities for traders with a market feel.

If the long volatility strategy earns the most profit in high volatility periods a negative volatility/vega position will often lead to cataclysmic results. If even short a $1000 worth of vega can suddenly erupt and produce losses of $100,000 if implied volatility moves 100 points. Therefore the prudent thing to do is to be neutral or positive vega during times of normal volatility.

During periods of high volatility trading one must also be vigilant that volatility doesn't just as easily reverse direction. Volatility at times can be crushed back down to its original levels, therefore traders must try to lock in some profit while the getting is good. In these cases the volatility trader should lock in some profit by selling some options and reducing his vega exposure. A large positive vega position will reward the trader in the transition to a high volatility environment but once there a large positive vega/volatility position can precariously expose a trader to great risk. Thus risk must be prudently reduced. This can be accomplished by selling options which will reduce the vega/ volatility component of the portfolio. It will also lock in profits without exposing the trader to further market risk.

Sometimes when the underlying stocks become volatile, the implied volatility of the options may stay the same or even drop. There are a few reasons as to why the underlying stock volatility and the implied volatility won't follow one another. Some reasons for this is that the market may already hold enough low-risk off-setting positions. Therefore, you may see times when volatility and the underlying stock go in opposite directions. There is also the possibility that there may not be any large short volatility holders who need cover and could potentially be squeezed. When there is an inversion between market prices and implied volatility it can be taken as a sign that the market place believes that the increase in volatility is temporary and that it will collapse back. For whatever reason, an implied volatility/ underlying stock volatility inversion in a high volatility period is likely to be disastrous time for a long volatility holder. Long ratio strategies will be particularly exposed to falling implied volatility at this time.

To offset the potential loss from the inversion, the long volatility strategy holder will have to earn profits from his gamma trading or ride the trend and let the delta run. Because implied volatility may drop in the event of an increase in stock price volatility, long ratio volatility strategies are not without some major financial risk under certain market conditions. Given these possibilities, a prudent strategy would seek to weigh the wings differently in a delta-neutral butterfly in the appropriate price direction up or down to take into account the possibility of an implied level inversion to high market stock price volatility.