What Is Volatility Trading?

Cryptocurrency and volatility are tightly coupled. After all, volatility is an important aspect of trading, and throughout the short history of cryptocurrency, volatility has been a source of discourse, with analysts claiming it is what hinders institutional involvement. When prices fluctuate, traders can make a profit (or post a loss) depending on their initial prognosis. Therefore, understanding volatility is crucial for successful trading.

Volatility trading means trading against the volatility of the market. It’s a derivative market instrument, as it represents a contract that is based on the volatility index of an asset, another index, or any other tradable instrument. An investment is volatile if its price aggressively moves up or down. The statistical measure of this dispersion is what underlines volatility trading.

Directional trading focuses on the prices, and your fortunes as an investor depend on the final price versus the expected price. On the other hand, volatility trading is primarily concerned with price movements rather than being a gains/losses metric. Instead of placing unidirectional bets on asset prices, a trader can engage in volatility trading, which is price-independent.

Currently, the world’s most popular volatility market, the Chicago Board Options Exchange’s (CBOE) Volatility Index (VIX), reflects the expected volatility in the US S&P 500 Index. VIX Options, according to CBOE, “estimates expected volatility by aggregating the weighted prices of the S&P 500 (SPXSM) puts and calls over a wide range of strike prices. Specifically, the prices used to calculate VIX values are midpoints of real-time SPX option bid/ask price quotations.”

How to Trade Volatility

In practice, the most common way to trade volatility is through options. An options contract is an instrument that gives the buyer or the holder the right but not the obligation to either buy or sell the underlying asset at a predefined price within a given period of time. The right to buy is the call option, and the right to sell is called the put option.

Volatile markets come with tremendous risk. However, when used correctly, options can help traders combat volatility and even profit from it, as follows:

  1. Sell calls to enhance your earnings
    Selling calls gives the buyer the right to purchase your assets at the strike price upon the expiry date. This earns you an instant premium that enhances your earnings.
  2. Buy puts to protect your assets

A put option can protect your assets or help you make speculative bets when the assets drop in value. Puts are more powerful since you limit losses to the instant premium.

  1. Collar (sell calls + buy puts) for low-cost hedging
    A collar is a combination of the two strategies. When combined, the instant premium from selling the call offsets the cost of buying the put.

Traders can also choose to trade volatility products. A great example in the traditional setup is the VIX, as mentioned earlier. This instrument allows investors to trade in the volatility of the S&P 500. Overall, trading volatility products are more convenient for investors but typically come with rules. But you don’t actually trade the VIX directly.

The market has various products that traders can use to capitalize on the opportunities that the VIX creates. An example is the iPath S&P 500 VIX Short-Term Futures ETN (VXX). Traders can use the VXX to hedge by going long when anticipating a market correction in the near future. This is especially useful if the VIX appears at the bottom, indicating that it cannot go any lower.

The following are some advantages and disadvantages of volatility trading.


Advantages

Disadvantages

Risk

Trading volatility can be less risky, as you use factors like implied volatility to take positions rather than taking directional positions.

Stock market prices are still a random walk, and volatility trading is not a guarantee to get it right.

Manner of trading

Unlike day trading, you can take up volatility options that mature over a longer period of time.

You can’t trade volatility directly. This means that traditional means of trading don’t apply.

Expertise

You can leverage knowledge on options and day trading to trade volatility effectively.

Investors need a decent understanding of directional trading to capitalize on aspects like implied volatility. 

Profits or loss

A calculated approach can maximize volatility positions without incurring the traps of day trading.

It’s a grind-it-out process, whereas directional trading is binary (you either make money or lose money).

Volatility Trading Strategies

In trading volatility, a number of factors come into play. For instance, for volatility options trading, you can take the annualized volatility level that the options contract value is equal to.

Equity indexes trade at a given price, typically exhibiting a certain realized level of volatility on an annual basis. This is the historical volatility of that index. That said, in volatility trading, you will often encounter the term “implied volatility” (IV), which is different from historical volatility. Historical volatility is the actual volatility demonstrated by the underlying asset to an option over a fixed period of time in the past.

Implied volatility is a metric that captures the market's view of the likelihood of changes in a given security's price. It accounts for current prices, not just the historical volatility over a fixed period. In this way, IV shows the projected future moves of the option. For instance, an IV of 25% on a $200 option shows a one-standard-deviation range of $50 over the next year. One standard deviation means to a 68% likelihood that the price of the option will end up either $50 above or below the current price.

Implied volatility is relevant when trading volatility ETFs because it looks at the future. Index volatility trading is contingent on traders’ perception of forthcoming instability. Instability in the market is what drives volatility. Using the example of VXX volatility ETFs, trading volatility depends on factors that cause instability in the S&P 500, including trade wars and manufacturing data.

However, volatility trading techniques are sophisticated and demand a proper understanding of directional trading and how options work. Basically, the foundation of volatility trading techniques is an understanding of the market sentiment on expected instability.

The idea is to engage in volatility trading positions that maximize market volatility within a specific time frame, which means grasping the implied volatility and being able to extrapolate correctly from that metric.  For instance, you can use an increase in IV to prepare for a bearish market in the near future. Bearish markets definitely come with more risk to the majority of equity investors. Traders will usually sell or write options when implied volatility is high because it’s akin to selling or “going short” on volatility. Conversely, traders can buy options, or “take long positions,” on volatility.

It’s important to note that implied volatility does not necessarily predict the direction of price swings. High IV simply indicates a larger price swing in either direction. Therefore, when using IV, it’s important to factor in other dynamics before taking up an option.

Volatility Trading Software

In the modern era, automated algorithmic volatility trading has a strong presence in the market. Computerized algo trading calculates precise entry, exit, and money management rules that can work for high-frequency trading volatility.

A lot of factors come into play when calculating volatility in real time. Volatility trading software improves trading efficiency and is an integral aspect of all kinds of trading. Investors can automatically work out the volatility spreads and ratios they need for smooth volatility trading.

For instance, you can automate ratio-writing when trading volatility. Ratio-writing refers to writing more options than you purchase. A simple ratio is 2:1, with two options sold, or written, for every option purchased.

A ratio like this aims to capitalize on a significant fall in implied volatility before the option expires.

Cryptocurrency Volatility Trading

Crypto volatility is influenced by a number of factors, including...

  • The relative infancy of the industry
  • General speculation
  • Low participation from institutional investors
  • The developing regulatory landscape

The punitive bear market of 2018 was a reality check for many who jumped into the crypto market during its remarkable rally in 2017. That dramatic slump saw the total crypto market capitalization decline sharply. In 2018, the market capitalization of most altcoins fell by over 90%.

In light of the dramatic rollercoaster, crypto volatility trading is the next best thing for market participants. At the moment, crypto volatility is high because of a unique convergence of factors. These coalesce to create sharp market movements and high volatility. It’s a double-edged sword, as day traders looking for fast markets can experiment with derivative contracts with high leverage. However, longer-term traders have to shoulder a significant amount of risk, which is not as prevalent with government bonds, for instance.

Crypto volatility trading offers an opportunity to explore a feature that makes many shy away from crypto trading. At the moment, few cryptocurrency exchanges cater to high-frequency trading. The scarce availability of HFT trading is understandable given the relative infancy of this industry.

However, you can take data from a cryptocurrency volatility index such as the Bitcoin Volatility Index or use similar sites to track the volatility of Bitcoin and other top cryptocurrencies. With a feel for the historical and implied volatility of the cryptocurrency markets, it’s easier to trade crypto volatility.

In trading crypto volatility, indicators that trigger crypto markets are highly relevant. When looking at the type of option (call or put), it’s prudent to undertake a comprehensive analysis. Sometimes it will make sense to acquire call options to enhance your earnings and other times to go with put options to protect your assets.

When trading cryptocurrencies in volatile markets, be cautious and...

  1. Be careful in taking market options, as volatility trading has to be a calculated and informed decision.
  2. Reduce your trading amount/what you put at stake, and in a fast-moving market, use features like leverage to make or lose more while trading less.
  3. Be patient, as the fact that volatility options are available in the crypto market does not mean you should be quick to jump at every opportunity. Wait for the right one.
  4. Manage risk. As the saying goes, don’t put all your eggs in one basket. At the end of the day, it’s never wrong to apply caution in your activities because options trading can be both extremely rewarding and extremely risky.

Bitcoin Volatility Trading

Bitcoin and volatility make for a fascinating love story, for lack of a better phrase. From Bitcoin’s launch in 2008, Bitcoin’s daily price movements have been a wonder to behold. The latter part of 2017 and the entirety of 2018 saw dramatic daily movements, with Bitcoin reaching a record $20,000 before plummeting back down to around $3,000.

Investors who hedged positions based on returns had mixed returns depending on when they got in and out of their positions. Investors who got into the Bitcoin market at the start of 2017, when prices were around $700, still made exceptional returns. However, the majority, who jumped on the bandwagon at $19,000 or around the peaks, had a very frustrating year of trading.

Incidentally, such a period of extraordinary volatility represents a tremendous opportunity for volatility trading. Remember, volatility trading is not concerned with profits and losses from the prices but rather how much the prices actually move, in either direction.

In 2019, Bitcoin has exhibited better stability by its wild standards. Nonetheless, day trading still incurs a significant amount of volatility.

Trading Volatility on Xena Exchange

Xena Exchange offers an unparalleled trading experience to make the most of the fast-moving market. At Xena Exchange, investors have a range of instruments to make trading more convenient, lucrative, and diverse. In addition, Xena Exchange offers advanced analytics and trading tools to make the experience smooth. With a detailed trading terminal, traders can keep up with market developments in real time.

Several months ago Xena Exchange launched XBTVAR — futures on the volatility of Bitcoin (to USD). This is the first exchange-traded volatility contract on the market.

The main advantage XBTVAR offers is the ability to get exposure to volatility in one click, without building a complex portfolio of options.