How to monetize Volatility in trading

Volatility or Implied Volatility is the favorite weapon of the non-directional traders. They want to make profit no matter where the market heads. We have all ready discussed much about Volatility in in some older posts. Here we will discuss how we can monetize volatility. Is it possible to monetize volatility?

When we refer Implied volatility, we refer volatility in case of the Option Trading. IV is the instrument that is derived from option trading. With help of Option we can trade volatility that has huge analytical values in it.

There are two types of option contracts that we have previously discussed in the post - Call and Put. Premium of these contracts depend on Underlying Price, Strike Price, Time to Expiry, Risk free Rate and Volatility. If other four things are supplied, you can calculate the Volatility.

Volatility has historical behavior and mean reverting characteristic. It means it never trend but ranging. And always tends to achieve its mean position. It does not survives the extreme either high or low. This is the characteristic why professional option traders love it the most. 

How to monetize volatility?

Answer of this question depends on the answers of the following questions:

1. How to find the extreme IV?

2. How to trade them?

For finding the extreme, one can use Implied Volatility Rank (IVR). We have this in this post.

Read Implied Volatility Rank here.

Drawbacks of IVR

Though IVR is a good indicator for finding the extreme, however it fails sometimes.  For example, India Vix (Index to Measures Volatility of Nifty) gives a sudden spikes in Volatility - IVR is unable to catch and incorporate it immediately. In simple words, it suffers with the outlier value.

To overcome this, we can use Box Plot of India Vix(In case of Nifty) that has power to catch each and every outlier value of volatility. Vix closes around 17 on February 24, 2020. You can figure it out where it falls on the plot.

Box Plot is the visual representation of the depicting groups of numerical data through their quartiles. Boxplot is also used for detect the outlier in data set. It captures the summary of the data efficiently with a simple box and whiskers and allows us to compare easily across groups. Boxplot summarizes a sample data using 25th, 50th and 75th percentiles. These percentiles are also known as the lower quartile, median and upper quartile.

A box plot consist of 5 things.

· Minimum

· First Quartile or 25%

· Median (Second Quartile) or 50%

· Third Quartile or 75%

· Maximum

In above Image, the first horizontal line represents the minimum, the middle line of the box is the median value of Vix and the last Horizontal line represents the maximum (upper extreme) of the value. The maximum and minimum are the values in between Vix ranges and try to achieve the median Value.

The bubbles represents the outlier value of Vix. For instance, Vix is 17 we can check it with plot - you will it is near its meridian. Say Vix is 25 - it comes under the outlier value or extreme value.

Answer to the second question, once we know that the IV is at the extreme, it gives you perfect ground to take a contra trade in the Underlying.

If IV is at extreme high, you can go for option shorting and if IV at lower end opens opportunity for option buying. Volatility cooling and rising gives opportunity for non-directional trade. To use volatility create Delta neutral position in option and make profit with help of Volatility. 

Disclaimer : The analysis has been prepared for informational and educational purposes only. It is not and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action.