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An Introduction to the Concept of

Volatility Trading

1.1 TRADITIONAL INVESTMENT AND VIEW TAKING

To make a profit, most individual investors and fund managers are forced to take a

view on the direction of the price of something. The traditional or fundamental

strategy is to study all the aspects of the market-place, all the factors affecting the

price or that might affect the price, the general state of the economy (if relevant)

and decide on the value of the investment vehicle under study. In addition to the

fundamentals, many also consider what are known as the technical factors.

Technical analytic methods use the sequence of previous prices to come up with an

investment recommendation. Using charts to discover particular price patterns

(hopefully repeatable) or to highlight trends is a very common technical tool.

Today, chartism has such widespread use that most investment institutions will

employ one if not more chartists and their language and terms are in common use

in the financial press.

When the average person in the street hears the term "investment", they usually

think of stock or equity. Traditionally, most private individuals and fund managers

restricted their attention to investing in the stock market and usually in their own

domestic stock market at that. Also, many investors would (or could) only really

attempt to capitalise on the price of a particular stock rising. If all the analysis

showed that a given stock was undervalued or cheap and that the rest of the world

had not yet discovered this (but were about to) then one bought and established

what is known as a long position. If the decision was right then the stock price

would rise and at a suitable

point one sold, realising a profit. However, if all the analysis indicated that a

particular stock was overvalued or expensive and that it was very likely that the

price would fall significantly in the future, then most private investors would (or

could) do nothing. With the exception of the USA, most private investors could

not capitalise on falling stock prices. You had to own stock to sell it. You could

not establish a short position (explained later). So until relatively recently, invest-

ment decisions were often restricted to domestic stocks and usually one had to buy

first and sell later.

All this was changed by the development and growth of the derivative product

industry. The private individual now has access to a much wider spectrum of

prospective investments via exchange traded derivatives. Rather than just

considering individual domestic stocks, it is now possible to take a view not only

on the level of the domestic stock index, but on almost every major foreign stock

index. In addition, derivatives trade on an enormous number of commodities

including energy, metals, grains and meats. And now it is possible to speculate on

the movements of many of the world currencies. But by far the largest growth has

occurred in the interest rate derivative market. Before 1970, if one took the view

that this or that government would increase or decrease interest rates, there was no

vehicle with which either the individual could speculate or the fund manager

hedge. Today, it is possible to take positions in short, medium or long-dated

interest rate derivatives in the US, European and Japanese markets.

Of course, one of the main advantages of derivatives is that it is just as easy to

take a negative (bearish) view as it is to take a positive (bullish) view. Derivatives

allow everyone to attempt to capitalise on prices falling without owning the

underlying entity. It is just as easy to sell at a high price first and buy at a low price

later as to do it the other way round, the usual way, of buying first and selling

second.

The growth in the information technology industry has led to the general

availability of more and more information to the fundamental analyst.

Developments in the personal computer industry have meant (hat extremely

sophisticated technical analysis software is now available tor the cost of a few

hundred dollars. And access to exchange traded derivative markets has meant that

almost anyone anywhere i-'an take a bullish or bearish position in almost anything

that has a price. However, whether following fundamental analysis or technical

analysis or a combination of both, the ultimate investment decision is that one has

to buy or sell something. The traditional investor has to

take a view on the direction of the price. If one is right, a profit is enjoyed, if not a

loss is suffered.

Between entering and exiting the trade many things can and often do happen.

The price of the instrument may rise or fall. The price may begin to fluctuate

violently or become moribund. The price may collapse 50%, stay at this depressed

level for several months only then to rise in an orderly fashion and to settle back to

the original entry price. The investor may make or lose money or possibly break

even, but every day the position would be valued according to the latest market

price. The value of the investment will vary from day to day to a greater or lesser

extent depending on market conditions. Most market participants refer to this

variability as volatility and volatility to most traditional view-taking investors is

not considered to be a good thing. Widely fluctuating prices can cause concern.

Increasing volatility usually means there is increasing uncertainty in the market

about the ultimate direction of the price.

The interesting point about the position of view-taking investors is that they are

really only concerned with two prices—their entry and their exit price. So in a

given year of say 240 trading days, if the investor gets into a position on day 60

and leaves on day 180, these two prices are all that are important. What happens

between the getting in and the getting out in a way is irrelevant. Between entry and

exit, the market may have been extremely volatile or very quiet. The view taker,

once in, is just looking for an exit point. The view taker, in a sense, is looking at

only one dimension of a price sequence—the direction. The view taker needs to

get the direction of this dimension correct. Some view takers are spectacularly

successful and seem to get the direction right more times than wrong. But many

view takers only manage to get it right 50% of the time and many consistently fail.

Most investors will agree that it is very difficult, even using the most sophisticated

techniques, to consistently pick price trends correctly.

The purpose of this book is to show that there is another dimension to

investment—trading the volatility of a price and not the direction. In the simple

example above, of the investor entering a trade on day 60 and leaving on day 180,

it is possible to devise strategies that will exploit any volatility that occurs between

the two days. More importantly, it is possible to devise strategies that. under

certain circumstances, will yield a profit without the need to take a view on the

direction of the price at all. These techniques that trade the second

dimension are known as volatility trades and the real attraction of them is that one

can completely ignore the first dimension.

Imagine entering into a position in a given stock and not caring whether the

price goes up or ^own. This is the very position of the volatility trader.

1.2 THREE EXAMPLES OF BUYING VOLATILITY

Before we go into the details of the more complex aspects of buying and selling

volatility it is instructive first to consider some simple examples. These examples

are simulations specifically chosen to highlight the irrelevance of view taking in

this strategy. In each example we consider a different path a particular stock takes

over the course of a year. For simplicity the year is split up into 52 weekly periods.

The stock price and the profit or loss to the strategy are recorded each week and

plotted in Figures 1.1 to 1.3. In all three examples the stock price at the start of the

year is set to 1,000 units (dollars, pounds, yen or whatever). To illustrate the point

that the profit or loss is independent of direction, the three examples depict

situations in which (i) the stock price rises over the course of the year. (ii) the stock

price falls over the course of the year and (iii) the stock price ends up unchanged.

How are the Stock Price Sequences Generated?

It is not really necessary to go into the details of how these sets of stock prices were

generated. There are many different methods of price simulation and probably the

simplest is to toss a coin. If the result is a head then increase the price by a given

percentage (say 0.5%). If the result is a tail then decrease the price by the same

amount. A method similar to but more complex than this, was used to generate the

three sets of simulations. The method used ensured that each price change was

independent of the previous price change. In this way the prices have •no memory",

or exhibit no particular pattern.

Is This Really Realistic and Does it Have Implications for the Profit and Loss

of the Strategy?

Some chartists would probably disagree with the simulations and say that these do

not represent a real life stock price process. Chartists

believe that prices are non-random. However, the important point to note is that

although these three examples are generated by random processes the strategy is

equally valid if the processes were non-random and had some hidden pattern. A

random process is used just to illustrate a point.

The Outcomes of the Three Strategies

The long volatility strategy is a simple set of trading rules that dictate the buying or

selling of either the stock or a derivative instrument related to the stock. Trading

only occurs when certain criteria are met. At no time is a view taken on the stock

price direction and at no time are forecasts of the future stock price required. Most

importantly, exactly the same trading rule is used in all three examples.

Example 1

In Figure 1.1 the stock price starts at 1,000 and over the course of the year

gradually rises to 1,300. The stock price increase is not in a perfect straight line.

There are fluctuations. The price does move up and down, i.e. there is some

volatility. In this example the up moves eventually dominated the down moves

resulting in a price rise of 300 points or 30% by the end of the year. The long

volatility strategy profit (shown by the dotted line) over the same period and using

the

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