How to Tackle Volatilty in the Options Market?

If you are in the capital market, then volatility is part and parcel of the game. Of course, by volatility, we mean that the markets fluctuate and add to your risk. For an option buyer, volatile markets are a good thing because the greater the volatility in the price of the stock, the better the chances of your option expiring in the money or ITM. However, volatility is something that intimidates most traders. So here are some volatile market tips. You can not only handle volatility but also make volatility work to your advantage.

Volatile market tips may look like a very short-term approach, so what you need is a volatile market trading strategy. That means you need a strategy that not only protects against the ill effects of volatility but also helps you to capitalize on such bouts of volatility. Here are some golden rules for you to handle volatile markets.

Tackle Volatilty in the Options Market

A typical volatile market trading strategy entails a strategic approach as well as an opportunistic approach to handling the risk of volatility. Here are 6 strategies for volatile markets that will combine and form your documented volatile market trading strategy.

There is a lot of power in asset allocation

Here is your first volatile market trading strategy and it is a fairly simple one at that. Volatility may be going up or going down in a secular manner over long periods but in shorter bursts, it is very disconcerting. One of the first and most simple approaches is to not abandon your long-term financial plan or your asset allocation plan as it is better known.

The logic is something like this. Irrespective of the volatility in the markets, your long-term financial goals in life are not going to change and you are still on target. Just ensure that you don’t just give up your financial plan and your asset allocation logic just because of volatility. On the other hand, in times of volatility, it is all the more essential to hedge your risks with asset allocation. Here is why.

Typically, your journey to long-term goals has some inbuilt checks and balances to handle volatility. Make the best of it. For example, a systematic investment plan or SIP is designed to make the best of market volatility. Since SIPs form the basis of your financial plan, they are essential to ensure that the power of compounding works in your favor. Secondly, and more importantly, when you follow a proper asset allocation approach, any deviations from the allocation are continuously corrected. So, you end up booking profits at higher levels and staying liquid at lower levels. That is the crux of a volatile market trading strategy.

Go long on quality and short on risk

What exactly does this mean? We are talking with specific reference to your equity and equity mutual fund portfolios. When markets are on a bull run, you tend to believe that it would never end. That is natural. Therefore, you optimistically load up on mid-caps, small caps, sector funds, thematic funds, etc. One of the basic rules is to avoid too much concentration risk when markets are volatile. One more way is to focus on stocks with historically high standards of transparency and corporate governance. They are your best volatile market trading strategy stocks. Thirdly, focus on higher growth stocks, high margin businesses, and market leaders within the industry. They are the low-risk outperformers.

Leverage options and futures to your advantage

If you are one of the investors heavily using futures and options as a low-margin alternative to cash market trading, there is a better choice in front of you. These are excellent risk management products and you can use F&O to handle volatility. It is in volatile markets that you should make the best use of these derivative products. If you are long on equities in a volatile you can use futures to lock in profits and also get the benefit of roll premiums. Put options of lower strikes can be used to hedge your risk and you can also do beta hedging with index futures to hedge the risk of your entire portfolio. If you are willing to be a little more adventurous and aggressive, you can also look at volatility strategies like straddles and strangles to make the best of volatile markets. You can even reverse these strategies and play on the short side for range-bound markets. The list can go on. But each of these volatile market trading strategies can be aptly applied.

When in doubt, diversify your risk

That is a truth that always holds you in good stead. How do you manage your asset mix when markets are volatile? Certain assets are not as volatile as equities during volatile times. For example, debt markets tend to be more stable when equity indices are volatile. So, adding some debt to your portfolio adds stability and assurance of regular income. Alternatively, asset classes like gold and REITS can also have a behavior that is contrary to equities. Gold ETFs or listed REITs can also be meaningful in these volatile times. The volatile market trading strategy here is to spread your risk and be prepared.

Play for rangebound markets with options

Options are asymmetric so they can be created with unique payoffs. For example, you can do a long strangle for a volatile market. Just invert the logic and you can do a reverse strangle to take the best out of range-bound markets. This is quite common albeit slightly riskier. However, you do have an option of a volatile market trading strategy, turned inside out.

Finally, doing nothing is also a strategy in volatile markets

You make profits in the market by entering at the right time, exiting at the right time, and also by doing nothing. That is hard to believe but true. That is the third strategy; when to do nothing. In volatile times, it is very easy to be lured into the market by trying to fish in troubled works. The basic rule is that when you do not grasp the undertone of the market, it is best to stay on the side-lines. In volatile markets, staying out at the right time and doing nothing can be an important volatile market trading strategy.

What is volatility

Volatility is the sharp movement in the price and it represents the risk in any asset class. Normally, volatility is measured by the standard deviation or by variance. Higher the standard deviation, higher the risk and lower the risk-adjusted returns. That is why volatility is a negative factor for equity valuations. However, in option pricing, the buyers of call and put options prefer higher bouts of volatility.

How are options priced?

Options are priced as the summation of intrinsic value and time value. Normally, intrinsic value is simple and it is a time value that is a lot more complex. That is why there is a dedicated formula called the Black & Scholes that is popularly used to price options. This pricing model is available in all trading terminals and also on the NSE website.