What is volatility trading?

By , CEO of Volcube.

What is volatility trading?

Volatility trading is the term used to describe trading the volatility of the price of an underlying instrument rather than the price itself. For example, one could trade the value of an equity index, but volatility trading typically means trading the expected future volatility of the index. Any instrument whose price moves, exhibits price volatility. Volatility trading is simply buying and selling the expected future volatility of the instrument. Rather than predicting whether the price of an asset will move up or down, volatility traders are concerned with how much movement, in any direction, will occur.

How is volatility traded?

The most common way to trade volatility is via options. The value of an option is affected by several factors, but an essential determinant of its value is the expected future volatility of the underlying instrument. Other things being equal, options struck on an equity index with higher expected volatility will be more valuable than options struck on an index expected to be less volatile. Options  therefore are a neat and simple way to gain exposure to the volatility of the underlying.

The price of volatility

The value of an option can be attributed to several components. By stripping these away, traders can imply an annualised volatility level that the option’s tick value equates to. This is known as the implied volatility. So an equity index may be trading at a certain price and it may have exhibited a certain realized level of volatility over the previous 12 months. Traders can compare this realized level of volatility with the current implied level as seen in the option market. However, there is a crucial difference here; the implied volatility level refers to the annualised volatility that is expected over the life of the option. In other words, it is forward looking and reflects traders’ current best estimate of what future realized volatility will be.

Volatility trading and Volcube

Volcube enables users to learn how to trade volatility via options. By trading options in Volcube, users can experience volatility trading first-hand and begin to learn the risk management techniques successful volatility trading demands.

Learning about options? Trade on the Volcube Options Market Simulator for FREE! Read more…

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