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Volatility has surged back into the markets, and the macroeconomic situation seems more uncertain than ever.
Consider this your volatility survival guide: Here are four tips worth keeping in mind if you want to survive and profit in this market.
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Survival Tip #1: It’s Better to Receive Than to Give Volatility
The in options prices runs consistently higher, on average, than the realized [actual] volatility exhibited by underlying assets. That means it is profitable, over the long run, to receive the value of those option premiums and pay out the value of the realized volatility. Experienced options traders accomplish this with familiar trades like , , and strangles.
Of course, in the short term, any given moment of high implied volatility might be a situation in which high option prices are actually justified — think of the fall of 2008 or, it seems, the spring of 2010. But over the long term, even after accounting for periodic market disruptions, strategies that collect the difference between implied and realized volatility tend to substantially outperform many other approaches.
Get
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Survival Tip #2: There’s More Than One Way to Measure Volatility
The most popular method for calculating historical volatility is to take the standard deviation over a certain period of the natural log of close-to-close prices. But a calculation that only considers closing prices ignores the information provided by intraday opening, high and low prices.
Consider comparing other models (like Parkinson and Yang-Zhang) to get a fuller sense of how volatile an asset has been.
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Survival Tip #3: Follow the News, but Trade Your Model
It’s easy to get caught up in the news flow surrounding the numerous areas of instability around the world — the euro zone crisis, growth prospects in the United States, politics in the Middle East, etc. — but it’s important not to let vague impressions about world events become the driving force behind trading decisions.
Even if you don’t follow a back-tested or quantitative strategy, it’s important to ensure that your trading is based on explicit criteria, rather than just the ebb and flow of world events. After all, the merely reactive nature of the decisions of most investors is precisely what generates trade opportunities.
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Survival Tip #4: Volatility Traders Should Trade the Underlying Asset, Too
Options traders who want to express a view about implied volatility need to isolate that variable and hedge away any other unwanted risks. That often means reducing delta, or the exposure to price changes in the underlying asset.
While it’s possible to hedge away delta exposure using options (via synthetic long and short positions), the simplest route is often to buy and sell shares of stock or futures contracts sufficient to offset the exposure in a position. Delta hedging is an essential component of any volatility trading strategy.
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