Idea of the Day Preparing for volatile markets

What: most people think of volatility as only relevant when markets decline and the Vix spikes, but this is not the full picture. Volatility is also high when the Vix drops and markets shoot higher, as we saw on Monday. In the current environment when political angst is high, particularly in the US right now, we need to get used to periods of elevated geopolitical risk that soon subside.

If we are about to witness an increase in volatility surges then it is worth making sure that your positions are protected. One way to do this is to use options, particularly if you trade equity indices.

How: At City Index we offer options on the major indices and FX pairs with spreads from 4-points, and we offer options on over 20 markets. The benefit of options is two-fold. Firstly, they can be used as a hedging tool. Rather than sell out of your positions every time Donald Trump tweets about North Korea for fear that the price will plunge, if you are long an index, let’s say the FTSE 100, if you are also long a put option – the right but not the obligation to sell the index at a pre-arranged time and price – then even if your actual index position falls, your option position should rise, which means that your net position is neutral.

The second way to benefit from options is to take a view on volatility. When you buy an index using an option you are essentially selling volatility, and when you sell an index using an option then you are buying volatility. Thus, if you believe that volatility is too low for the current geopolitical environment, then you would buy volatility using a put option.

Another benefit of options is that you only pay the premium upfront, which as we mention above starts from 4-points with City Index. If you make the wrong call and the market doesn’t move in your favour then you can always let the option expire worthless, and you have limited your losses to just the premium that you paid upfront.

Options are sophisticated trading products, so it is worth doing your research to find out if they are for you. In the current choppy market environment they can come in very useful.