October 22, 2008, 5:59 am

A play on volatility?

by: The Financial Blogger    Category: Investment, Market and Risk,Trading
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See this graph? It’s the VIX? Many of you might have huge question marks in your head right now. Ok, so the VIX is a volatility index, it is calculated using the variation in prices of equity options. Basically, the more this index goes up, the more the market is assuming that markets will move in a violent manner. As we’ve discussed in the past few weeks, the returns of stocks have been going up and down (ok.. mostly down!) in ways that have not been seen in a while. For a stock market to move over 5% in one day is a very rare event in normal times (imagine that they often move by less than that in a whole year).

But as you can see in this graph, we are reaching levels of volatility that are heads and heels over the (already high in some regards) volatilities of this summer. Like any stock movement, this creates important opportunities. While I will not discuss trading volatility directly here (it is a very quantitative market to trade in and is usually not done on stock markets but rather as OTC products.. so not really geared towards individual investors).

But there are still many different ways to play this, especially if you believe that volatility will go down and believe that this is the opportunity of a lifetime. One of the less risky ways to do this is to find an investment you are looking for. Let’s say you like the OIH (see graph below) and are thinking of buying the stock, it is currently trading at 98$.

To profit from the volatility, you buy 100 stocks and sell one contract on the January 2009 options, the 110 calls. For this, you will get 1325$ or so.

So basically, you are buying 100 stocks * 98$ = 9800$

You are selling 1 option contract = 1325$

So your net cost is: 8475$

Basically, you bought OIH for 84.75$ while it is already worth 98$.

A catch? Of course, nothing is free. But this one is actually not too bad. What are you giving up is a huge return between now and mid-January.

So for example, if the stock moves above 110$ by mid-January, you will have to sell (because of the option) for 110$, so you will make 11,000$-8475$=2525$

That is a 30% return.

So either you buy this stock at 98$ or you buy it at 84.75$ but capping your 3 month performance at 30%… for me, option #2 is the best one. I won’t mind too much even if the stock reaches a lot higher…

I did this example with OIH but it can work with most options right now with high volatility. Of course, you have to do due diligence like any stock because if it goes down, you will lose money.

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Comments

I agree this writing covered call is one way of hedging our position.

The thing with this approach is that no protection on the downside. When the price goes to below $84, we will still be losing money.

Yes, exactly… that’s why I put it in red… this is not an investment recommendation. But rather, a suggestion to look, when investing in a stock, at selling call options, especially when volatility is this high… I don’t really see it as a hedge, more as a way to increase profits on a given trade

As financial advisor, do you recommend buying put options to protect investment?

I guess when we were bullish like last year, nobody even cares about buying put options.
Nowadays, buying put options is simply too expensive.

by: The Financial Blogger | October 23rd, 2008 (6:28 pm)

Antony,

I actually prefer to have a good asset allocation that answers the client’s need (i.e. reduce volatility to his own risk tolerance).

PUT is more for active trader, not financial planner’s client 😉