Buying and Selling Volatility. K. Connolly


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, investment 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 down. This is the very position of the volatility trader.

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