The Advantage of Recognizing Implied Volatility in your Trading Strategies
Volatility is one of the most mis-used tools of the futures options trade in my humble opinion. First thing we need to do is understand what implied volatility means. Implied volatility is a mathematical measurement of the perceived price uncertainty in the underlying futures contract over a specified period of time. A good example of this price uncertainty is this summer’s corn market.
Corn implied volatility was running 10-15% since July of last year as the market was mired in a range from $3.35 to $3.85. The large 2018 crop coupled with the demand uncertainty created by the Chinese tariff situation had convinced the trade that prices were going nowhere. The algorithmic fund trading programs also recognize the price malaise as an opportunity to squeeze any remaining “juice” out option premiums. All this translates to a compression in volatility or price uncertainty. Well, little did the trade know that Mother Nature would start raining in mid-April and not allow the farmer to plant his corn crop until early June. As the market realized the uncertainty of the eventual crop, implied volatility jumped to over 30% by mid-May and eventually over 35% by mid-June! What was once a certainty that we would have plenty of corn, was now disrupted by the inability to put the crop in the ground. Corn prices responded by rallying over $1.00 in a month. Then, as a further reaction to perceived price uncertainty unfolded, corn prices broke $1.00 from the late June highs to current price levels. Ample moisture was joined by heat and suddenly late planting concerns were replaced by ideas of yet another big crop. Is that enough price uncertainty for you??
These price swings demonstrate the rationale behind buying “cheap” volatility and selling “expensive” volatility in your strategies. In each instance, the market got too convinced of price direction for it’s own good. When volatility gets too cheap for too long, you want to look for opportunities to buy lottery tickets. When price uncertainty screams, you want to look for ways to incorporate selling irrational exuberance into your strategies. December corn $5.00 calls were trading from 5-6 cents on January 11th. They rallied to 30 cents on June 17th. Two weeks later, they were trading at 9 cents. Now we all know hindsight is 20-20, but this is a perfect example of why you need to buy the dumps, sell the humps and not diddle in the middle!
The speculator needs to view cheap volatility as a potential buying opportunity. Conversely, the hedger needs to incorporate selling expensive volatility into his hedging strategies. It’s not complicated and everything comes at a price. The seller assumes a much greater degree of responsibilities and risk, but it is my opinion that these variables can be managed. Use volatility to your advantage. Let these ebbs and flows of implied volatility give you an advantage in your trading.
There is significant risk involved in trading futures and/or options on futures. Futures and/or options of futures trading may not be suitable for all investors. Investors should consider these risks and evaluate their suitability based on their financial conditions. Past performance is not indicative of future results.