Expected and observed volatilities – Real life experience By Dr. Bobby Srinivasan and Dr. Sudhakar Balachandran

February 4, 2016 | Posted by bobbysrinivasan << back to blog

Trading in options is one of the best tools available to take advantage of all short-term fluctuations. Eminent finance professors have tried different methods and models to track the fluctuation as well as its impact. They use surrogate variables such as interest rates, dividends, volatility index and try to price the options. The option pricing using this formulates unfortunately does not capture all market fluctuations in prices. Traders need tools to make money from the volatilities and hence cannot count on this rigorously developed mathematical equations. The reason is simple. When political or economic event takes places the traders rush to create volatility by taking highly speculative positions. They believe in the adage, “you can make money when the market is going up. You can make money when the market is going down and still you can make money when the market move sideways”. Here is a current example of wo they react to the market information.

On January 4, 2016 the Chinese monetary authorities released monthly data on the Purchase Managers Index (PMI). It was expected to be 48.6 but instead it turned out to be 48.2. The participants in the Chinese and the Shanghai market took this information to mean that the Chinese economy is all set to go down. They are currently growing at 6.9%, which according to them is already unacceptable. When this unfavourable news turned up, both these stock market prices plunged around 6 to 8% in value immediately. The Chinese government in order to ward off panic closed the activities of these exchanges. At the slightest unexpected outcome the Chinese investors are ready to throw in their towels taking the cue. The Japanese Nikkei, the Singapore ST index and the Indian Nifty all took heavy corrections. The panic became contagious and even pulled the US stock market down considerably. Normally, it is said that when the US market catches cold the global markets suffer the flu. But now the story is other way around.

Who is to blame and why is this happening? I feel that one should blame the easy money policy. All countries stock markets are grossly overpriced partly due to vary low interest rates. The traders and investors have borrowed huge amounts of money around the world and if any slight mishap happens to the market they all rush to exit. According to the data available nearly 9 trillion US equal dollars is floating around thanks to quantitative easing the US, Japan, Euro and Britain. Expansion of liquidity resulted in banks loaded with funds which they indiscriminately made it available to speculate. The current crisis is very much resemblance of 2008 sub-prime crisis. Most of the governments around the world have adapted popular measures such as providing subsidies and other benefits to their citizens. In this environment, the average saver is bothered, if he puts the money in the bank, the return on investment is much lower than the inflation rate. Again if he puts his money the market, the big funds come and create such fluctuations that he quits the game by paying a high price.

The moral of the story is that the observed volatility does not have much theoretical foundation and happens when the market participants are least prepared for it. It is clear that 2016 will be year to remember for the presence of extreme volatility in the market. For the investors and traders in this market, the following strategies are recommended.

Buy puts and calls at the money (Buy strangle) on the correction phase (Gap down) the puts will reward you big time and on the revival phase the calls (Gap up) will produce amazing results.
If the direction is clear but not the time. Buy or sell the future and roll it over the expiring period to the next periods until the predictions come true.

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