Volatility must be taken into account when sizing positions, setting stop losses or taking any exposure at all. The higher the volatility, the more the chances of logging big gains or losses. Scenarios of high short-term volatility favour certain types of trading strategies, while low short-term volatility may favour another type.
Will volatility in Indian equity and derivatives fall or rise in 2014 versus 2013? I expect a rise in volatility in 2014 versus 2013. This is due to domestic political uncertainty and the rising chances of tapering affecting global liquidity.
This is a contrarian view. Many major foreign institutional investors (FIIs) appear to believe that a stable, business-friendly government will be installed sometime mid next year and hence, the market will be up-trending and have lower short-term volatility. Also, the economy is quite likely to bottom out fairly soon and higher earnings visibility may be accompanied by less volatility.
If the majority view is right, there may still be a spike in volatility around the period of the general elections. However, we would see trending markets for most of the year, with volatility dropping in short-term periods. The majority view seems to be reflected in the current state of market volatility. Volatility peaked in August-September and has since fallen steadily. The market has trended up during most of October and November.
If the majority view is wrong, we would see a spike in volatility around the general elections and short-term volatility would continue to rise once political instability becomes apparent after the elections. In certain situations, we may see a trend reversal around the elections (from bearish to bullish or vice versa), coupled to reversals in volatility patterns.
Either way, we may reasonably expect a rise in volatility during the lead up to the elections and, perhaps, for a while afterwards, unless someone wins a clear majority. If you are unwilling to make a directional bet, it is possible to make money in a situation of high-short term volatility by use of options. If short-term volatility is high, for example, buying far-from-money strangles will be profitable.
One very simple method of judging volatility is using the daily high-low range. This can be normalised as a percentage of the daily closing value. If we use this simple measure, the average daily volatility of the Nifty since January works out to about 77 points a day, or about 1.3 per cent. If we extend this calculation to a rolling 20-day period, we note that the Nifty had, on average, moved around 476 points in every 20-session period of 2013, so far. In median terms, it has moved 447 points in every 20-session period.
This is roughly an averaged 7.5-8 per cent swing in every 20-session period. In August-September, it was swinging by much more. It had a high-low range of 800 points for a while and in late August, the range was over 1,000 points. That was over 17 per cent in terms of the prevailing prices of that period. Since October, volatility has progressively fallen and in the latest 20-day period, there is a difference of 370 points between the 20-day low (5,972) and the 20-day high (6,342). Volatility at its lowest has ranged at about 170 points for any given 20-day period. That is, around two per cent.
A trader who repeatedly bought near-term Nifty calls and puts with strikes at about five per cent off the money would be paying approximately one per cent for each combined strangle position. This strategy would have been profitable because the strangle would have made money fairly often, and it would have returned multiples in several months.
If 2014 follows the same pattern, the same strangle strategy could continue to generate profit. Look out for this possibility until the next general elections at least. If a stable government is established, you may change to a directional strategy. If instability continues, this strategy may continue to work.