Decaffeinating Portfolios Via Volatility; It May Seem Counter-Intuitive, but Volatility Can Actually Be a Stabilizing Force for Your Portfolio. Volatility-Based Strategies Are Typically Non-Correlated to Traditional Techniques and Often Result in Smoother Equity Growth If Properly Employed. Here, We Exploit Volatility Trends in Starbucks

By Klein, Hendrik | Modern Trader, June 2008 | Go to article overview

Decaffeinating Portfolios Via Volatility; It May Seem Counter-Intuitive, but Volatility Can Actually Be a Stabilizing Force for Your Portfolio. Volatility-Based Strategies Are Typically Non-Correlated to Traditional Techniques and Often Result in Smoother Equity Growth If Properly Employed. Here, We Exploit Volatility Trends in Starbucks


Klein, Hendrik, Modern Trader


Most traders consider sophisticated option strategies complex financial instruments, designed for pros only. As such, these techniques are often overlooked as a way to tap changes in volatility as a source of returns. However, volatility-oriented trading strategies can stabilize an investor's portfolio because of their non-correlation to traditional investments. Volatility-based strategies can reduce overall portfolio risk and provide insurance against external shocks.

Theoretical foundations for volatility were laid by the German mathematician, Gauss, as in the Gausschen normal distribution, which works on the principle that coincidental values fluctuate around a middle value in the shape of a bell curve (log normal distribution). Economists Harry Markowitz, Fisher Black, Myron Scholes, Robert Merton and William Sharpe expanded on this in their formulas regarding portfolio theory and option-pricing models (see "A Black-Scholes Peek at Futures Prices," page 38).

The definitions of volatility refer the time of the calculation and the dates that serve as a basis for that calculation. Historical volatility refers to the actual annual variance of profit to prices. Implict, or implied, volatility is calculated from current market variables using an option-pricing model. On the basis of these two volatilities, the options trader estimates expected volatility and if he is correct, the expected volatility correctly forecasts the future volatility.

Options theory assumes constant volatilities for different options. Sophisticated analysis software allows different base prices and terms to be displayed graphically. In this ay, volatility resembles a rough ocean with continuous waves and changing wind directions and strengths. Experienced options traders can ride the virtual waves to generate non-correlated profits with minimal relative risk.

The different volatility profiles are also described in terms of skew/smile. Skew/smile is the volatility curve cross-section. A number of options strategies are available to profit from deviations in these: straddles, strangles, vertical spreads, calender spreads and many more. The constantly changing market risk is balanced out by the basic values that make up delta hedging. The delta displays how strongly an option or an option portfolio has been influenced in its option price by the market direction.

SKEW/SMILE

Skew/smile shows a cross-section of the volatility surface and allows us to calculate implicit volatility independently of different basic prices at a given term (see "Smile vs. skew," right). For most individual equity and index options, the lower the basic price, the higher the implict volatility, as extraordinarily strong negative price crashes occur more often in practice than is accepted in the oretical models.

This attribute is why options buyers pay higher risk premiums (or sellers demand higher premiums) for put options, which are expressed in the form of higher implicit volatilities. In addition, investment funds often acquire shares via buying from put holdings and simultaneously selling covered calls. Additional premium income can thereby be cashed and can still have a negative effect in the case of extremely quick rising markets due to missed price profits. In practice, quick price movements tend to go down. Upward movements tend to take place in an ordered and slow fashion.

[GRAPHIC OMITTED]

A steep skew gradient can result from two factors: the risk attitude of the market participant or supply/demand forces, according to hedging elements. These factors are constantly changing so that options with the same basic price, but different terms, can display different implicit volatilities, and the skew curve can have a flatter or steeper distribution. Furthermore, the skew for interest and currency options is quite different to that of share options.

"Volatility surface" (right) shows the implicit volatility of options for different strike prices and expiration dates. …

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Decaffeinating Portfolios Via Volatility; It May Seem Counter-Intuitive, but Volatility Can Actually Be a Stabilizing Force for Your Portfolio. Volatility-Based Strategies Are Typically Non-Correlated to Traditional Techniques and Often Result in Smoother Equity Growth If Properly Employed. Here, We Exploit Volatility Trends in Starbucks
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