Trade volatility if you want to take a view on the markets
WHEN people think of volatility, images of falling stock prices, anxious traders and massive losses come to mind. But spread betters should use periods of volatility as an opportunity.
Most spread betting companies allow traders to take a position on volatility – usually by betting on the Vix index, which measures the implied volatility of options on the S&P 500. So why trade it? If you think the market has risen too far then you should go long volatility. For example, if the market is not properly pricing in all of the downside risks and volatility is low, then you should think about taking a long position.
You can see this on the chart below. Volatility fell consistently from the start of this year through to the end of April, which mirrored the peak in the markets: in February the FTSE 100 was hovering around the 5,100 mark, before peaking at 5,800 in late April. But May and June were a bloodbath as the markets reacted to the European financial crisis and headed south, reaching a low of 4,800 at the end of June.
RISK APPETITE
But can you use volatility as a way to predict market movements? Yes, says David Jones from IG Index: “It’s another way to take a directional view on the markets.”
A recent report from Moody’s has suggested that sentiment (another way of describing volatility) is coming to dominate market behaviour.
It notes that the yields on junk bonds and the Vix have become positively correlated in the past decade. In the past, high yield bond prices were often driven by fundamentals, but now they are more and more driven by market sentiment. Hence, financial markets can move higher or lower based on the appetite for risk. For example, the markets soared from March 2009 even though Western governments were racking up unsustainable levels of debt, which the market only started to price for in May this year.
TRADING OPTIONS
Trading volatility is also getting easier. You don’t just have to trade the Vix to get exposure to market sentiment; you can also trade options. If volatility is high then options prices rise and vice-versa. Jones says that it’s better to stick with trading options on big stock indices such as the FTSE 100 rather than individual companies, since volatility tends to reflect overall market sentiment. You can also trade currencies, for example US dollar-sterling, euro-US dollar and US dollar-yen, which are deeply sensitive to risk appetite.
Periods of low volatility can be deeply frustrating for spread betters since they suggest that markets will keep moving in the same direction (usually upwards). But volatility can be created by using binary trades. Jones explains that binary bets are a yes or no proposition.
So if the FTSE is trading at 5,200, and you expect it to finish up on the day then you would buy the binary. If you are correct and the FTSE finishes at 5,220 then you win. Binaries are always settled at 100, regardless of how far the index moves, so if you buy the binary used in this example at 35, then your upside is 65 points. One of the attractive features of a binary is that you have a fixed loss and you can only lose what you put down in the first place.
If risk appetite is starting to dominate market movements, then spread betters should be comfortable trading voltility as any other asset class.