Market Observations with Rob Kirby

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Chaos Known as Volatility

by Rob Kirby, Kirby Analytics. April 10, 2006

With the commodities bull market s-t-r-e-t-c-h-i-n-g o-u-t, it’s continuing to make its mark on investors' psyches. While the price movement for commodities in general has been "up" – each commodity has taken its own particular path to higher price; some ascending more or less up in a straight line, like homes. Other commodities – like precious metals – their prices tend to move ahead a few steps, and then take a couple of steps back. More often than not, Jane and Joe investor attribute this back and forth or see-saw price movement as "increased volatility."

But Would You Believe It?

Classic thinking by most investors would lead them to believe,

If $100 gained 30 percent in even years and lost 10 percent in odd ones, it would grow to about $480 in 20 years... If it grew 10 percent every year, you'd end up with about $673.

Therefore, volatility is the bad guy.

I borrow the example above from isigma.com because they point out that,

"..losing money every other year for twenty years is bad regardless of volatility. The reason this hypothetical investment underperforms 10% per year is because the geometric mean of -10% and +30% is less than +10%. Basic statistics tells us that

[(1 + 0.3) * (1 - 0.1)]0.5 -1 = .082 or about 8.2%".

Without trying to confuse folks with "arithmetic mean" – I use this example to make a point. The point is that a good many folks would mistakenly conclude that the see-sawing price in the example above is more volatile than the one that grows at an even 10% per year. That's because,

Volatility is measured without regard to direction, so a price change from $10 to $11 is no more or less volatile than a price change from $10 to $9. Of course these measures of volatility are all dependent on the timeframe of measurement.

In case you find that hard to believe,

So long as you are measuring over a period of greater than two years, an instrument that goes up in price 10% per year is actually more volatile than an instrument that alternates between +30% and -10%.

So, if you're really thinking smart - volatility can be looked upon as the good guy!

Trade Volatility But Avoid Getting Ploughed

So how does one benefit or get harmed from volatility, anyway? Traders who generally get harmed by volatility tend to be,

"..value investors (the kind that buy if the present price is below the present value, in hopes that the future price will converge to the present value), spread arbitrageurs, and technical analysts who rely on 'overbought' and 'oversold' indicators. Nearly all the market participants in this group subscribe to economic theories based on 'equilibrium models.' These investing styles work quite well so long as volatility remains within the bounds assumed by the trading model in use, just like picking up $100 bills in front of a moving bulldozer. Eventually, it moves out of those bounds".

Whereas, folks who benefit from volatility tend to be,

"..option buyers, certain types of fundamental traders, trend traders, and fractal traders. Since volatility is bounded only on one side, at zero, the traders who survive and succeed in the markets are those who put themselves in a position to benefit from volatility. Traders in this group are the ones driving the bulldozer."

But What Are The Secrets of the Trade?

As you may have surmised, profitably trading "volatility" typically employs the disciplined use of futures and/or options depending on ones view [bullish or bearish] in a particular commodity or market:

Bullish Market Strategies

Option StrategyDescriptionReason to useWhen to use
Buy a callStrongest bullish option position.Loss limited to premium.Undervalued option with volatility increasing.
Sell a putNeutral bullish option position.Collect premium.Large credit bullish market. High or increasing volatility.
Vertical Bull CallsBuy call, sell call of higher strike price.Loss limited to net debt.Small debit, bullish market.
Vertical Bull PutsBuy put, sell put of higher strike price.Loss limited to price difference minus credit.Large credit, bullish market.

Bearish Market Strategies

Option StrategyDescriptionReason to useWhen to use
Buy a putStrongest bearish option position.Loss limited to premium.Undervalued option with volatility increasing.
Sell a callNeutral bearish option position.Collect premium.Option overvalued, market flat, bearish.
Vertical Bear PutsBuy at the money put, sell out of the money put.Loss limited to debit.Small debit, bearish market.
Vertical Bear CallsSell call, buy call of higher strike price.Loss limited to strike price difference minus credit.Large credit, bearish market.

Neutral Market Strategies

Option StrategyDescriptionReason to useWhen to use
StrangleSell out of the money put and call.Maximum use of time value decay.Trading range market w/ volatility peaking.
ButterflyBuy at the money call (put), sell 2 out of the money calls (puts), and buy farther out of the money call (put).Profit certain if done at credit.Any time credit received.
CalendarSell near month, buy far month, same strike price.Near month time value decays faster.Small debit, trading range market.
BoxSell calls and puts same strike price.Profit certain if done at credit.Any time credit received.
RatioBuy call, sell calls of higher strike price.Neutral, slightly bullish.Large credit and difference between strike prices of options bought and sold.
ConversionBuy futures, buy at the money put and sell out of the money call.Profit certain if done at credit.Any time credit received.

While the bullish/bearish/neutral tables above outline some of the common strategies employed – special market situations are also worthy consideration:

Special Market Situations

Option StrategyDescriptionReason to useWhen to use
Straddle PurchaseBuy put and call at or near the money.One option will go in the money.Options under-valued and market likely to make a big move.
Covered callBuy future, sell call.Collect premium on calls sold.Neutral, slightly bullish.
Covered putsSell future, sell put.Collect premium on puts sold.Neutral, slightly bearish.
Synthetic futures position.Buy call (put), sell put (call).Neutral, slightly trending market.When the net positions is better than futures.

A Few Concluding Points

Put simply, volatility is a positive measure that marks a change in price over a specified time period. Whether or not an investor benefits from an increase in volatility depends on how they are positioned. Increases in volatility may arise equally from positive or adverse price movements in underlying commodities or markets.

Instruments most often used to trade volatility are generally viewed as sophisticated. The strategies outlined above are typically practiced by sophisticated, well capitalized investment professionals [typically well heeled individuals or hedge funds] and profits or losses can be magnified greatly through the leverage that is inherent in these products.

While any and all investors benefit from an increased understanding of the investment landscape, trading in these instruments is not recommended for novices.

Resources:

Today's Market

Overseas equity markets began the week on a sour note with Japan's Nikkei Index dropping 106 points to close at 17,456. North American markets fared better but ended the day mixed with the DOW up 21.29 to 11,141.33, the NASDAQ down 5.70 to 2,333.30 and the S & P up 1.10 ending the day at 1,296.60. NYMEX crude oil futures ended the day 68.75 – up 1.35 per barrel on the day.

In foreign exchange markets the U.S. Dollar Index improved by .12, ending the day at 89.43. The dollar did manage to drop marginally against the Chinese Yuan, ending the day at 8.0034.

In the interest rate markets yields were virtually unchanged from Friday's close with the 2-year. bond at 4.89%, the 5-year. at 4.89% and the 10-year bond ended the day at 4.96%.

The precious metals complex put in one of the oddest days on record. Bullion prices [as measured by COMEX futures] soared, while the gold and silver share prices were sold off. COMEX gold futures ended the day up 9.60 finishing the day at 598.80 per ounce while COMEX silver futures closed at 12.55 – up .45 per ounce on the day. Against that backdrop, the XAU managed to lose .57 to close at 144.90 while the HUI gave up 1.80 ending the day at 343.62.

Wishing you all a pleasant evening and happy tomorrow!

Rob Kirby

© 2006 Rob Kirby

Contact Information

Rob Kirby | Proprietor, Kirby Analytics Newsletter - Proprietary Macroeconomic Research
Toronto, Ontario, Canada | Observations | FSU Editorials | E-mail

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