Volatile markets always attract traders to trade more. This is because with more volatility comes a lot of movement and with movement comes a lot of opportunities to make money. However, one must not forget that increase in volatility also brings in additional risk.
Let us discuss how to get the best out of this volatility in terms of the opportunity without getting exposed to bigger risks. The best way to profit from volatile times is by trading it using options. Let us understand, why options are better first.
We all have gone through the trades where due to our tight risk management, in such volatile times we end up losing even though we had a right trade on our hands. Let me put this in numbers,
Buy Stock X @ 100 SL 98 TGT 104
The stock after we bought hits a low of 97 and then closes at 106. This is a typical volatile market scenario, where we know that if we lower our stop loss by just a rupee or two, we may still be able to achieve the target. Were we not right on choosing the opportunity? yes, we were. Should we not have kept the tight stop loss? well, we must.
What follows has come from a lot of traders after their decades of experience.
The chance of Hitting the stop loss and Breaking Down is almost Equal to the chance of Hitting the Stop loss and Reversing in Volatile Times.
So, here Option becomes a better option.
If we had bought an Option, we could have stayed in the trade without being worried too much about the strictness of the stop loss. We may just get alerted whenever the stop loss level gets hit in the underlying stock/index. We can then trigger a stop loss on our Option.
Remember, in worst case scenario too, we are not going to lose more than the premium that we have paid on the Option, which is generally between 5-10% of the value of the stock.
Apart from avoiding being stopped out of a winning trade and keeping a small Maximum Loss in all trades there is one more reason for Option being a better option for Volatile market conditions
We all have seen losses in our option trades because of passage of time. While in consolidating times this may be a big concern, in volatile times it may not be.
The choppiness or the volatility will make sure that that the rise in Option premium due to extra movement (when in right direction, of course) is higher than the fall in premium due to passage in time.
Also, remember volatile market conditions are generally characterized by bigger moves in stocks and indices. So, a big move in one trade in right direction can make our Option premium rise multifold. This can help us generate returns that could be much better than trading in stocks or indices futures.
The reason for volatility could be anything from a war in Ukraine to onset of a Pandemic, but both on the Risk front and on the Returns front, Option is a better Option for trading during Volatile times.