In the second article of our four-part series, we explore the concept of volatility and learn how to both protect against volatility and how to use it to your advantage.
Why measure volatility? In most cases, volatility is a key metric used to gauge the risk associated with a security. In essence, the more volatile a security, the riskier it can be perceived. In the financial world, greater risk is typically met with investors’ higher compensation expectations for their capital.
Several methods exist to measure the past, present, and future volatility of your portfolio. Let’s explore a few examples.
Standard deviation quantifies the extent to which a given stock’s returns deviate from its mean value. By considering all the risks associated with a stock, including systematic (market-wide) and non-systematic (company-specific) risks, standard deviation offers valuable insight into its volatility.
A common interpretation is that stocks with higher standard deviations are more volatile. To better comprehend the potential movements in a stock’s price, we can associate probability distributions with standard deviation. The concept of normal distribution is closely related to standard deviation, allowing us to identify a range of fluctuations associated with a certain probability of occurrence.
For instance, if a stock exhibits a standard deviation of 7%, there is a 68.2% probability that its return will fall within the range of -7% and +7% over a specific period. This information aids in assessing the likely changes in the stock’s price and making informed investment decisions.
The beta coefficient is a valuable metric to assess how a stock’s price is expected to react compared to the overall market movements. It quantifies the stock’s systematic risk, which represents the portion of risk that cannot be diversified away through portfolio construction.
The formula for beta is obtained by dividing the covariance of the stock’s return and the market returns by the variance of the market over a specific period. Here is the beta formula:
Beta (β) = Covariance (Stock Return, Market Return) / Variance (Market Return)
In this formula:
Covariance measures how two variables (stock return and market return) move together. A positive covariance implies that the stock tends to move in the same direction as the market. By contrast, a negative covariance indicates an inverse relationship.
Variance quantifies the dispersion of market returns from their average. It represents the market’s inherent risk.
Beta is easily accessible and widely available, eliminating the need for individual calculation. This measure is primarily utilized to determine whether a stock’s price will move in sync with the broader market or behave differently.
So what does this all mean? Simply put, a beta of less than 1 implies the stock is less volatile than the market. This implies a potential lower risk in comparison to the market. On the other hand, a beta greater than 1 signifies a stock is more volatile than the market, indicating higher risk.
It’s important to consider beta values when assessing a stock’s risk and aligning it with an investment strategy that matches risk tolerance.
Another measure of volatility that is important to understand is called the Maximum Drawdown. This metric helps quantify the worst possible loss experienced by a stock or portfolio during a given period.
The Maximum Drawdown is simple to calculate. It is the difference between the highest peak and the lowest trough of a stock over a given timeframe.
The advantage of using Maximum Drawdown lies in its ability to reveal what is known as “bad” volatility, specifically focused on losses. Since risk by default can never be fully avoided, investors must accept the best option to minimize losses.
By incorporating Maximum Drawdown into portfolio analysis, investors can identify stocks with promising earnings potential while reducing the likelihood of severe losses. This measure helps investors to identify a balance between risk and reward, and adapt investment strategies accordingly.
The CBOE Volatility Index, known to most investors simply as the VIX, provides real-time insights into the market’s expectations regarding future fluctuations in the S&P 500 index over the next 30 days.
The VIX may also go by the nickname the “fear index”, because it reflects the level of uncertainty plaguing the market. A VIX reading above 30 implies investors are operating with heightened fear and uncertainty while a level below 20 implies stability.
Canada also has its equivalent to the VIX that measures volatility in the Canadian market. It is known as the VIXI or S&P/TSX 60 VIX.
Two crucial points to consider when interpreting the VIX are as follows:
Investors can trade options or futures on the VIX index or its Canadian counterpart via exchange-traded funds (ETFs) and other derivative tools. The VIX itself is merely an index which is a measuring tool rather than a financial instrument.
Another essential measure of volatility is known as vega which quantifies the impact of changes in the underlying stock’s volatility on an option’s price.
The math behind vega might seem complicated at first, but easy to understand with an example. An option with a vega of 0.20 will see its value rise by $0.20 for every 1% increase in implied volatility.
It is crucial to understand that buying options will increase your portfolio’s vega, making it more sensitive to changes in volatility. On the other hand, writing (selling) options will reduce your portfolio’s vega, making it less susceptible to fluctuations in volatility.
By monitoring vega, investors can assess how their options positions may be affected by changes in market sentiment and volatility levels. Understanding vega is important for protecting or enhancing portfolio performance during different market conditions.
To learn more, read The Greeks – Vega.
Here are a few strategies that can be implemented to reduce your portfolio’s volatility.
This strategy is mostly used when you anticipate an increase in a stock’s price but its short-term price movement is difficult to model. To employ this approach, you simply purchase a put option.
By buying a put option, you acquire insurance that should generate a return if the stock falls below the option’s strike price. The risk associated with this strategy is the premium paid to acquire the option. If the expected loss occurs, you have two choices: sell your options to secure a profit or wait for them to be exercised. The second option can be more attractive if your perspective on the stock’s long-term prospects change and are no longer favourable.
The formula to determine the number of options required to protect your position is as follows:
Number of options to buy = (Number of shares in your possession) / 100
For example, if an investor holds 600 shares of ABC and wants to secure protection against a potential drop in its price, they can calculate the number of options to buy as follows: Number of options to buy = 600 / 100 = 6
In this case, acquiring 6 options would be necessary to safeguard the 600 shares.
For further insights into this strategy, we encourage you to consult the Montréal Exchange Strategy guide – Protective Put. It provides more in-depth information on protective puts and their implementation.
A long straddle is another method to protect yourself from volatility. This strategy is often used when you expect a significant price movement in the underlying stock, such as earnings seasons. The long straddle enables you to capitalize on both rising and falling share prices.
The straddle is categorized as a neutral strategy, as it involves purchasing a put option and a call option with the same strike price and expiry date. By doing so, an investor expects to profit when the stock price moves in either direction. The risk is limited to the premium paid for acquiring the options, while the potential profit is theoretically unlimited.
Let’s consider an example. Shares of DEF currently trade at $135 a piece. An investor can buy an at-the-money put option for $2.75 and an at-the-money call option for $5.75.
The investor will generate a positive return if DEF rises above $143.50 or falls below $126.50 before expiration date.
As an example, suppose the share price drops to $116. The profit realized would be calculated as follows: (exercise price – share price – premiums paid) * 100 = ($135 – $116 – $8.50) * 100 = $1,050.
For more comprehensive insights into this strategy, we encourage you to consult the Montréal Exchange Strategy guide – Long Straddle. It offers further details and guidance on implementing the long straddle to protect against stock volatility.
What exactly is meant by a Sector Option? Do we mean index options?
Sector options refer to options that are tied to specific sectors of the market, providing investors with a more effective way to express their views compared to individual stock options. While the protection offered by sector options may not be as accurate compared to individual options, it still represents a valuable tool for managing risk and exposure.
To illustrate, let’s consider the example of falling interest rates, which often create a strain on the financial sector. Instead of selling part of your portfolio or buying options on each individual bank stock, an investor can instead opt for a put option on the S&P/TSX Composite Index Banks (Industry Group).
One of the key advantages of using sector options is the significantly lower trading costs involved. This is because a single sector option can offer exposure to a group of related stocks, rather than individual stocks where multiple transactions are required.
While sector options may not offer the precision of individual options, it can serve as a practical and efficient solution for expressing market views and managing risks within specific sectors. For a more in-depth understanding of this topic, the Montréal Exchange’s Derivatives Indices guide offers valuable insights.
For further reading on related topics covered in this article, you can find additional articles directly on the blog:
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