Written By: Eklavya Guneja
Hello there! Ever heard of volatility in the context of the stock market and wondered what it really means? Don’t worry – you’re not alone. In this blog, we’ll understand volatility and its impact on options.
What Is Volatility?
Volatility is simply how much and how quickly a stock (or the market) can move up or down. Think of a cricket match where the score changes rapidly with every ball—that’s high volatility. If the score creeps up slowly, it’s low volatility.
Imagine you’re tracking the price of onions in your local market in Mumbai. Some weeks, onions might cost ₹30 per kilo; other weeks, they shoot up to ₹80 per kilo. That’s a clear sign of high volatility – prices swing a lot in a short span. If onion prices stayed around ₹30 to ₹35 each week, that would be low volatility.
Why Does Volatility Matter for Options?
When you buy or sell an option, you’re essentially betting on where a stock’s price will go. Volatility matters because:
- Higher Volatility: The stock could swing more, offering bigger potential gains (and bigger potential losses). So, options on a more volatile stock often cost more.
- : The stock’s price stays relatively stable, so options tend to be cheaper.
Implied vs. Historical Volatility
There are two main types of volatility you should know:
– Historical Volatility (HV)
This tells you how wildly a stock’s price has moved in the past. It’s like checking old weather reports to see how often it rained last month.
– Implied Volatility (IV)
This is all about the market’s guess for future movement. It’s like a weather forecast—people are looking ahead and guessing how the stock might behave.
Example to Illustrate
Suppose Reliance Industries has been trading between ₹2,300 and ₹2,500 for the last year. That range informs its Historical Volatility.
If traders suddenly think Reliance will announce a major deal, they might expect a big price jump or drop, pushing up the Implied Volatility – even if Reliance’s price hasn’t moved yet.
Volatility Trading Strategies
You don’t just have to react to volatility—you can trade based on it. Here are two simple strategies:
Long Straddle
– Goal: Profit from high volatility, regardless of whether the stock goes up or down.
– How It Works: You buy both a call option (betting on a rise) and a put option (betting on a fall) at the same strike price. If the stock moves a lot in either direction, one of these options could become very profitable.
Example
Rajan believes TCS might have major news after its quarterly earnings. He buys a call and a put option at the same strike price. If TCS jumps up or plunges down, Rajan’s gains on one option can outweigh the loss on the other.
Short Straddle
– Goal: Profit when volatility is expected to stay low.
– How It Works: You sell both a call and a put option. You earn premiums upfront, hoping the stock’s price remains stable. If the stock doesn’t move much, you keep the premiums.
Example
Meera thinks HDFC Bank’s stock won’t move much this month. She sells a call and a put option at the same strike price. If she’s right and the stock stays within a narrow range, she keeps the option premiums as profit.
Volatility Events and How to Manage Volatility in Options
Certain events can trigger sudden spikes or drops in volatility:
– Earnings Announcements: If Infosys is about to release earnings, traders might expect big swings and bid up the prices of its options.
– Budget Announcements: When the Union Budget is near, the entire market can become more volatile, affecting the prices of both call and put options.
– Global News: Factors like crude oil price changes or international policy shifts can affect Indian markets in unexpected ways.
– Watch the News: Keep track of important dates (like RBI policy announcements or company results).
– Check Implied Volatility: If IV is too high, it might mean options are expensive. If IV is too low, it might mean you’re getting a bargain—but only if you expect a big move.
– Set Limits: Always decide how much you’re willing to risk and set stop-loss orders to protect yourself from unexpected swings.
Volatility is the heartbeat of options trading. It influences whether options are cheap or expensive, and it opens the door to both thrilling opportunities and hidden risks. By knowing the difference between implied and historical volatility, you can better judge when to buy or sell options – and why certain strategies might suit different market conditions.
Keep learning, keep experimenting, and remember that the more you understand about volatility, the better equipped you’ll be to make informed trading decisions in the ever-changing world of the Indian stock market.
Happy learning, and here’s to making finance-friendly and approachable!