Avoiding Volatility Tax. Introduction to Volatility

Transcription

1 Mastery Series Today s Class Introduction to Volatility Understanding Volatility in Stock Understanding Volatility in Options Volatility Tax Tax Collection Strategy Introduction to Volatility What causes volatility? At the most basic level, volatility is driven by market sentiment. To understand what causes a change in volatility, we must understand what causes a change in trader sentiment. New economic data (earnings) New innovations Leadership Changes Herd Mentality Political Changes Interest Changes Currency Fluctuations And on, and on, and on... PAGE 1

2 Volatility as a Tool Volatility as a term has become synonymous with price swings but in reality it is a study of probability. By understanding the probability of future price movements, a trader can then establish a more accurate risk profile. Professional traders constantly monitor risk. By measuring historical price swings (Volatility) we can apply some simple statistics and establish a model that analyzes the probable future price movement of a stock. Warning: Don t get lost in the math! If you manage the risk, the profit will take care of itself. Understanding Volatility in Stock Historical Volatility Historical Volatility Defined: A statistical measurement of the fluctuating price movement of an underlying security over a given period of time. Results are presented as an annualized percentage. Example 1: A $50 stock with a 30 day Historical Volatility of 20% is expected to move between $40 and $60 for the majority of the year. Example 2: VZ is trading at with a 30 day Historical Volatility of 22%. Over the next year VZ is expected to trade within and (Chart on next page) Reading a 30-Day HV measurement is much like saying: Based on what we know from the last 30 days there is a 68% chance the price will be between and. PAGE 2

3 PAGE 3

4 Historical Volatility (continued) Standard Deviation: 1 Standard Deviation should include 68.2% of all moves. 2 Standard Deviations should include 95.6% of all moves. During a strong trend, you might want to give more weight toward the 2nd Standard Deviation. Based on the trading behavior in February 2014, there is a 95.6% chance that AAPL will trade between and for the next year. The higher the Historical Volatility the greater the opportunity for future price fluctuations. The higher the opportunity for price fluctuations, the greater the opportunity for risk. Increased risk potential can also create increased opportunity. PAGE 4

5 Average True Range ATR was created by J. Welles Wilder to create a picture of short-term price movement. It seeks to forecast how much the price of a security could fluctuate in a given day. As the name implies, it is the Average of a certain number of True Ranges. A True Range is the largest measurement of the following: The distance from the current high to the current low. The absolute value of the current high less the previous close. The absolute value of the current low less the previous close. The True Ranges that ATR averages does include gaps. It is similar to Historical Volatility in that it helps forecast future price volatility. ATR is represented as an average price and not as a standard deviation percentage. PAGE 5

6 PAGE 6

7 Average True Range (continued) A popular ATR setting is 14. I prefer 10, which represents two full weeks of trading. ATR is very useful in setting stops and avoiding whipsaws. During a trend, you can use ATR to measure a buffer for your stop below an exponential moving average. Half the ATR is a good rule of thumb. We are starting to get a complete picture of volatility within a security. Historical Volatility gives us a statistical probability on price fluctuations for the upcoming year. Average True Range gives us a sense of how the price of a security is moving from day to day. PAGE 7

8 Beta Beta helps us understand how the volatility of a security relates to the overall market. The beta of a stock is most often measured by relating it to the S&P500. Generally speaking, a stock with a Beta of 1 will move in direct correlation with the S&P500. Stocks with a beta less than 1.0 will be less volatile than the S&P500. Stocks with a beta greater than 1.0 will be more volatile than the S&P500. PAGE 8

9 Beta (continued) Beta is often used as a volatility tool, but it is actually a measurement of a stocks correlation with the S&P500. Stocks with a negative beta in general move inverse to the S&P500 (ex: SDS). Stocks with a zero beta might still be more volatile than the S&P500 if their movement is unrelated to the overall market. Knowing the beta of a stock you are about to trade will help you determine how much the value of the stock might be impacted by volatility in the overall market. How do you know the volatility of the market? That leads us to the volatility indices! PAGE 9

10 Volatility Index: Part 1 The most popular volatility index is the VIX. VIX was copyrighted and made popular by the CBOE in It is designed to give an indication of sentiment within the S&P500. Generally speaking, the VIX plots inversely to the S&P500. The VIX is plotted as a percentage of the overall Implied Volatility of the S&P500. Before we can fully understand the VIX, we must first understand Implied Volatility. PAGE 10

11 Understanding Volatility in Options Options and Volatility Consider the word itself - Volatility It describes wild, unpredictable movement. Volatility is the enemy of certainty! It creates risk potential. Remember, one reason to buy an option is to help manage our risk. Somebody must be willing to sell you that option and therefore assume the very risk you are trying to avoid! The seller and the market maker are in agreement... more risk means more premium can be required for the option being purchased! This fluff is extra premium being paid to the seller of the option for being willing to take on a little extra risk. Options and Volatility There are 7 factors that establish the value of an option: Type of option Stock price Strike price Expiration date Interest rate Dividends paid Volatility We can calculate the fair market value of a given option by using a pricing model. Black-Scholes is a popular model. PAGE 11

12 Option Pricing: DDD Type of option: Put Stock price: Strike price: Expiration date: 23 Days Interest rate: 0 Dividends paid: 0 HISTORIC Volatility: Theoretical Put Value: 1.39 Actual Put Value: % More! Implied Volatility: 68.63% PAGE 12

13 Implied Volatility Implied Volatility is a subjective percentage used to define the value of options based on potential risk. When Implied Volatility is over Historical Volatility, the options will be more expensive than theoretical value. When Implied Volatility is below Historical Volatility, the options will be less expensive than theoretical value. The rule of thumb is this: When IV is low - BUY (on sale) When IV is high - SELL (collect the fluff) PAGE 13

14 It is important to recognize the trend of Implied Volatility. Just because IV is 25% that doesn t mean it is either high or low. You must compare it to previous measurements. PAGE 14

15 Vega Shows the impact that a change in Implied Volatility has on an option price. Vega is considered one of the option Greeks. Measured in cents.03 Vega would mean that for every 1% Implied Volatility moves it would change the option price by $0.03. Vega will decrease as time approaches the expiration of the option. PAGE 15

16 Volatility Tax Volatility Tax Collection A tool developed by market gremlins to move cash from the ignorant to the well informed. In anticipation of increased volatility, acquire options at a discount and be prepared to sell them at a premium. Earnings will increase IV Product releases will increase IV News will increase IV Anything that could cause the price of the underlying security to move significantly will increase IV. Remember, vega is your friend! Advanced trade a straddle. The increase in IV can often balance out the losing leg. PAGE 16

17 Volatility Tax Collection (continued) If volatility snuck up on you and you still want to enter a trade, consider a credit strategy: Credit Spreads Covered Calls Naked Puts (Caution!) Remember, you want to be the one always COLLECTING the volatility tax You can scan for stocks with high or low Implied Volatility (ivolatility.com). Volatility Index: Part 2 Now that you understand Implied Volatility, you can better appreciate how the volatility indices provide an overall sentiment for the market. There are three main Volatility Indices: VIX - tracks IV of the S&P500 VXN - tracks IV of the NASDAQ VXD - tracks IV of the DJIA Instead of considering these volatility indices as an indicator of fear I have found it more valuable to reference the complacency of the market. A low IV overall tells us investors are not too concerned about any large moves. Extreme complacency or extreme panic are both unsustainable. PAGE 17

18 Final Thoughts Making Volatility Part of Your Plan Check implied volatility before trading an option. Check Vega to see how changes in volatility might impact your trade. Remain aware of volatility pitfalls like large Bid-Ask spreads. Be intentional with the timing of your trades during volatile events. How must my trading plan change to account for volatility? My Volatility Safeguards I don t trade over earnings. Period. I look for options to buy about 2 to 3 weeks ahead of earnings, and I collect the volatility tax by selling right before the report is released. I do not trade counter market with stocks that have a beta greater than.75 (and currently are trending with the market). I use Historical Volatility and ATR to help me understand where the market should be trading and where it should not be trading. PAGE 18