Volatility and its impact on derivatives

As seen in the previous chapter, various derivatives are a powerful tool in controlling portfolio risk. Investors can use different instruments, such as futures and options, to hedge against unfavorable market movements, thus making their portfolios better insulated against market movements.

Volatility is not an uncommon term that we hear tossed around when referring to the stock market, but what does it specifically refer to in the context of derivatives? A simplified definition of volatility is basically the degree of fluctuation beyond the average return of that particular financial instrument over a continuous period. The higher the level of volatility, the bigger the price swings. When there is low volatility, prices swing relatively little. For traders or investors who use derivatives as their investment tool, understanding this volatility is essential for making suitable and well-informed decisions and better risk management is also possible.

Volatility and Derivatives: The Basics

Derivatives are financial instruments that derive their value from the value of an underlying asset, such as stocks, indices, or commodities. In our market, NSE and BSE handle equity derivatives, while MCX and NCDEX deal in commodities. The volatility of these underlying assets drives the price action, thereby driving the price of the derivative.

Greater volatility creates the possibility of greater returns or losses because derivatives are extremely sensitive to changes in price on the underlying. This makes volatility a critical factor to the trader.

Role of Volatility in Option Pricing

Options are among the most common derivatives that provide a holder with a right, but not an obligation, to purchase or sell an instrument at a specified price. There are two kinds of options: a call or a put option.

Volatility is one of the most important factors in option pricing. High volatility increases the likelihood of extreme changes in the price of the underlying, and thus options are more valuable. In contrast, if volatility is low, the probability of favorable price movements is reduced, and an option will be less attractive.

High volatility mostly drives option premiums change on the back of election results, budget announcements, or even global disruptions.

Volatility and Futures: How to Manage Risk and Opportunity

A futures contract is an agreement to buy or sell any asset at a predestined price on a pre-specified date in the future. The volatility of the futures market contributes to greater scope for losses and gains. For example, if the Nifty 50 index shows wild movements, its futures traders profit from such movements. Yet, with greater volatility come greater risks. Traders quite often use hedging with futures. Assume a trader expects market volatility due to an announcement of RBI policy and gets into a futures contract to cover his portfolio from losses. If in case the expected volatility does not materialize, the trader will result in losses in the form of a future contract.

Volatility and Trading Strategies

High volatility in India occurs during global financial crises, political events, and changes in policy. Volatility aware traders modify their strategies immediately to take advantage of short-term price swings or hedge long-term positions.

It is popular to use the likes of straddles and strangles, by buying both a call and put-to take advantage of a significant movement in either direction, once it offsets the cost of the options.

Conclusion

Volatility has become a key player in the derivatives market, determining option pricing, thereby affecting futures contracts, and influencing trading strategy. However, while volatility may open up avenues for gaining better profits, it also elevates risk. A trader will know when to adjust to volatility in order to make better decisions in the derivatives market.

As volatility continues to shape the markets, mastering interest rate derivatives becomes essential for navigating the complexities of modern finance. We will understand interest rate derivatives in the next chapter in detail.