I was recently talking to a seafarer who was preparing for vessel duties after a brief Covid-19 break. Him being an engineer, I was curious about his thoughts on the almighty wind that is a persistent presence when at sea. He had this to say: “While sailing, wind ranges from a mild breeze to heavy cyclones. Heavy winds are really troublesome which lead to heavy ocean swells and waves, causing rolling and pitching of the ship. This makes it very uncomfortable for the sailors, while also increasing the ship’s fuel consumption.”
Volatility takes the position of the wind, in stock markets. It is most visible in a sideways market, where there is constant tussle between bulls and the bears. It is also present in an uptrend. If you look under the lens, you can see that for every few ticks higher, there are a few ticks lower, though substantial enough, which is why you call it an uptrend. When such cross currents become large enough to match the main current that is when the volatility becomes more perceptible, and is acknowledged by the participants as start of a reversal or a phase of sideways market. The same analogy works in a downtrend as well. In other words, it is a constant companion. But we acknowledge it only when market falls, which also partly explains why we do not generally desire volatility.
Why do we not like volatility?
Volatility is a leading indicator towards change. Change invokes resistance, because it forces us to readjust our priorities, our goals etc. not to speak about admitting to self, and an error in judgement. Matter of fact, volatility is perceived to be higher when stock markets turn from a peak, because, generally, investors are long, and to that end, volatility is often associated with the pain of losing. In fact, volatility may at times be higher when market turns from lows, but the volatility perception is not as high during such times, as it is to the liking of the long heavy investors.
What is there to like in volatility?
This starts with the acceptance that volatility being a constant companion, the onus is on making the best of it, rather than giving it a grumpy face. What begins with acceptance, can evolve into a fruitful experience, if we learn to understand the beast that volatility is.
For the option trader who mulls on whether to lay hands on ITM or OTM strike, the decision is usually a function of how much capital is available for commitment, as well as the confidence regarding the direction. In a way, they are not two separate things entirely, as capital does not become an overbearing decision, if directional clarity is higher. So, the choice of OTM, while also attracting lower investment, is more in line with giving some more cushion towards getting a feel of the direction without incurring much losses. How an OTM helps towards this end, is by having a lower IV, a measure of volatility than ITMs, in general. Volatility also increases if there is uncertainty and vice versa, and this can be understood by comparing it to an insurance that you buy to protect your asset. This insurance will get pricier if the there is uncertainty regarding the asset, and vice versa.
A direction agnostic option trader, who is here to make a play on the premiums rather than direction, also uses volatility or IV as a gauge to pick whether to buy or sell an option. Here IV is compared with historical volatility to understand whether it is relatively high or low. In an oscillating market, low IVs usually attract buying, while high IV with respect to historical volatility, is considered for selling. Of course, there are exceptions to this rule. However, it must be noted that volatility is a key element in the option pricing formula, and premium drops quickly when volatility falls, and vice versa.
IV is an even more integral aspect for option strategy traders. For example, you would want to buy a straddle/strangle, if you expect volatility to increase, and vice versa. In fact, often times, it is easier to take a call on volatility rather than direction.
Volatility can be used as a guide for the stock trader too with a little bit of understanding about VIX, which is a gauge of volatility of Indian stocks. VIX is computed using Nifty options and is denoted as an annualised percentage. It denotes the investors’ expectation of market’s volatility for the next 30 calendar days. So, in a falling market, if VIX were to rise substantially, then it can be taken as a signal towards bearish exhaustion and a subsequent turn higher. Alternatively, in rising market, if VIX were to rise substantially, then it can be taken as a signal that participants have begun to lose clarity, hinting at a potential downside.
At the end of the day, trading is less about seeing volatility as an avoidable element, and more about seeing it as an essential element of stock market, and riding it.