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Volatility Play

Brandon Wendell
Instructor, CMT

While teaching the Professional Trader course in India, I was able to learn a lot about how the markets work in India and more importantly, how to take advantage of that knowledge.  In speaking to a student, they mentioned that I should look at how volatility changes dramatically in stocks near the end of March.

March is the end of the fiscal year.  One thing that is for sure is that people will be looking for ways to offset gains they will have to pay taxes on with losses they had.  This is especially true in years where the stock markets have been bearish.  If a successful businessman has made many profits from their normal income source, they can reduce their tax liability by selling stock positions they have been holding for a loss.

This increased selling can cause the markets to stall in bullish moves like we have recently seen in the Nifty.

Additionally, the increase in selling can increase volatility in the stocks.  Volatility is a measure of how much uncertainty there is in the stock due to a potential (or historical) increase in the movement of the stock’s price.  If there is little movement in the price, then volatility is low.  But if there is large movement, then the volatility increases.

Mass selling of assets can cause a large spike in volatility.  One of the ways we can measure volatility is by using the technical tool, Bollinger Bands®.  The bands measure two standard deviations from the average price.  If prices are deviating further from the average due to an increase in volatility, then the bands will widen.  If volatility decreases, the bands will tighten.

So how does one use this knowledge?  Trading options!  Many option traders lose out on profits because they focus too much on the direction the stock may take while ignoring the volatility.  Volatility generally has a larger impact on option premium and can cause traders to lose on option trades even though they picked the right direction.

When volatility is high, the premium for options is also high.  When volatility drops, so does the premium.  Knowing that this occurs, means that a trader should choose whether to be a buyer of options or a seller of options based on where they believe volatility is currently and where they think it will move during the trade.

This brings us to the tax trade.  In years where the markets have been very bearish, the selling of bad positions to offset income can increase volatility in March.  An astute trader can buy options prior to this rise in volatility to profit from it.  Once the volatility and premiums have reached an extreme, then the position can be reversed and the trader can sell options to receive profit from the drop in volatility.

It is not as simple as buying March options at the February expiration and then selling in mid-March.  There is more to making the proper selection for your option trades.  Come and join us at one of our Professional Options Trader courses to learn how you can profit from this and many other strategies in the derivatives markets.
