What is Volatility And How Do You Trade It?

The newcomer to the field of volatility and volatility trading can be forgiven for finding it all to be rather confusing. If you have just come across the term you might have any number of questions to ask. Some, using the term in its ordinary, everyday fashion might wonder how you could ever trade in something as transitory and insubstantial as volatility. Others, familiar with the financial usage might still be at a loss as to how the price fluctuations of an underlying financial instrument could be traded. There are answers to all of these questions but we will only have time to touch on them in a short article like this. Those whose interest in the subject has been whetted by this will find that there is no shortage of further reading in which to indulge. In truth, volatility trading is a large subject. Books have been written about it.

To answer the first of our theoretical newcomer’s questions, volatility, in the sense that it refers to volatility trading, is simply the amount in which the price of some underlying financial instrument varies in the future. The answer to the second question is somewhat more involved. To put it simply the person who indulges in volatility trading is making a forecast of the volatility of some instrument over a particular period of time. The market itself also makes predictions about the implied volatility of the instrument. In the volatility trade, the trader will profit if his or her forecast of the realised volatility is more accurate than the markets.  The trader will try to achieve a higher profit by finding an instrument in which the implied (market) volatility is higher or lower than the trader’s forecast for the actual realised profit. If the implied volatility is lower than the forecast then the trader will purchase and hedge to make what is known as a ‘delta-neutral’ portfolio with the underlying instrument. If the opposite is the case then the trader sells the option and hedges instead to maintain the position.

The introduction of hedging adds a whole new layer of difficulty to what is already something of a complex subject. If we add to this the significance of the ‘delta-neutral’, the presence of Vega, add in the ‘fear factor’ and mention that the complex mathematics underlying the analyses which lead to both the implied market forecast and the trader’s forecast of realized volatility then the puzzled newcomer might become entirely baffled and decide to leave this field of finance to those better versed in the dark arts! This would be unfortunate as volatility trading offers many opportunities for traders and is a field which can be mastered by those who are prepared to knuckle down and master the basics and then study the more advanced and arcane aspects. It is definitely true to say that though volatility trading might not be the most immediately comprehensible method of trading it is certainly one worth your attention.

Spread betting, CFD trading and Forex are leveraged. This means they can result in losses exceeding your original deposit. Ensure you understand the risks, seek independent financial advice if necessary. The value of shares and the income from them may go down as well as up. Nothing on this website constitutes a solicitation or recommendation to enter into any security or investment.

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