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Chapter 4 Applications Of Volatility

Volatility based stop loss

Volatility helps determine how much a security can move over a given time frame. Knowing how much a stock can move within a stipulated time frame can help us decide the stop loss instead of getting stopped out due to random fluctuations in price. Volatility based stop loss helps manage risk as well as ensures that your stop loss does not get triggered due to whipsaws.

For instance, if you are a short term trader and know that Sun Pharma has a tendency to move 25 points over the course of 3 days, by setting a small stop loss less than 25 points while trading over this timeframe would result in a high chance of the stop loss getting triggered due to price fluctuations in the stock.

Steps to compute the stop loss based on volatility. The stop loss is computed based on the previous day’s closing price of the stock.

a) Compute the daily volatility of the security. (Readily available on NSE website)
Eg Hero Motocorp has a daily volatility of 1.26%

b) In order to trade in the stock the next day, we determine the stop loss by subtracting the daily volatility from the previous day’s closing price.

3760-(1.26%*3760) = 47.37

Hence, the trader can consider maintaining a stop loss of slightly more than Rs 47.37 while taking an intraday position in the stock.

For the positional trader who considers to take a position over a few day, stop loss can be computed as Previous Closing Price-( Previous Closing Price*(Daily volatility*Square root of no of days))

E.g. The stop loss over a 5 day period can be calculates as

Stop Loss=3760-(3760*(1.26%*Square root of 5))

Stop Loss = 3760-3760*2.81%

Stop Loss=3760-105.6

The stop loss for Hero Motocorp can be placed below 3654.4.

Traders also tend to make use of volatility indicators to determine the stop loss. Commonly used indicators are

a) Bollinger Band

b) ATR

Benefits of using volatility stop loss

There are times when we may not get a price action formation as a stop loss while trading. In such a case, volatility-based stop loss comes handy. It acts as an effective trailing stop loss. Also since volatility stop loss is an objective method, it is easy to compute for trades.

Calculating a securities move for any time frame

Determining the range a security could trade in can be extremely useful for traders in the derivative market. Implied volatility is made use of to determine the upper and lower range for the security for a defined timeframe. This expected range is used by option writers to decide which option to write while option buyers use it do decide the strike price to purchase or to create spread positions.

Determining the range

So, if we want to determine the range Nifty Futures could trade in for the FEB2018 series, we compute it as follows:

Nifty Futures Cmp (1.23.2018) 11080
Implied Volatility (ATM CALL IV +ATM PUT IV)/2 14.03
Calendar days for Expiration in FEB2018 series 30 (8 days of Jan Series+22 days of Feb Series)

Likely Movement =11080*14.04%*Square root of (30/365) = 446 points

Hence we could expect a movement of +/- 446 points in the next 30 days.

Expected upper range 11080+ 446= 11526

Expected Lower range 11080- 446= 10634

Hence, an option writer can consider selling strikes above 11550CE or below 10600PE. This is the range Nifty Futures is expected to trade in provided there is no major unexpected event that causes the implied volatility to jump up significantly.

Option Strategies based on Implied Volatility

Implied volatility is a dynamic figure that changes based on activity in the options marketplace. Usually, when implied volatility rises, the price of option also tends to surge provided all other factors remain constant. So, when implied volatility increases after an option has been purchased, it is good for the option buyer and bad for the option seller.

Conversely, if implied volatility decreases after the option has been purchased, the price of options usually decreases. Option sellers tend to befit in such a scenario.

Option strategies that can be implemented based on Implied Volatility

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