Derivatives Market Volatility: How to Navigate and Profit from Turbulent Markets

Markets experience recurring cycles of booms and busts, going through alternating periods of economic prosperity followed by periods of decline and recession. World events such as economic trends, wars, pandemics, elections, and climate change heavily influence these boom and bust cycles. During the COVID-19 pandemic in 2020, we witnessed the prices go through extreme volatility when global equities, commodities, and other assets took a treacherous fall, followed by a remarkable recovery of the markets thereafter.

This article explores the various derivative strategies used to navigate and profit from turbulent market conditions. Depending on the user's perspective of the volatility, whether it represents increased risks or potential lucrative opportunities, derivatives products such as futures and options can provide tools to achieve their objectives.

Hedging - Managing Price Risk Using Derivatives

Hedging is a risk management strategy investors use to offset potential losses in one asset by taking an opposite position in another. You can think of it as insurance for your investments. Just as you buy insurance to protect your home from unexpected damages, hedging helps protect your assets from market downturns.

For example, if you own stocks and fear that the market might decline, you could hedge by taking a short position in the stock index futures or Single Stock Futures (SSF). If your stocks lose value, the gains from selling the stock index futures or SSF can help offset those losses. By taking a position opposite to the underlying asset held, hedging removes adverse price risks of the underlying asset.

If you own stocks, you could also employ options for hedging by buying put options to protect against losses. If the market declines, the put options increase in value to offset losses of their underlying stocks. The benefit of using put options is that you can manage your downside risk while maintaining upside potential for your stocks.

Profiting From Large Price Fluctuations

High market volatility allows traders to profit from strong trends and large price swings. Depending on their view of the market direction, a long or short position in the futures market can generate profit from these price fluctuations since futures are leveraged and can enhance returns greatly when prices move strongly. Traders, however, will need robust risk management and stop-loss strategies to protect against losses if the position does not turn out as planned.

A trader taking a directional position in futures could also consider using the same hedging concept by buying an at-the-money put on the underlying futures contract if the trader is long futures or a call option for a short futures position. The option will protect the futures position from downside risk while maintaining the profit potential for the position.

For example, if you take a long position on the FTSE Bursa Malaysia Kuala Lumpur Composite Index Futures (FKLI) at 1600 and expect a strong bullish move, you could buy an FTSE Bursa Malaysia Kuala Lumpur Composite Index Options (OKLI) Put option at-the-money 1600 strike to protect any downside before the expected move develops.

Volatility Play with Straddle and Strangle Option Strategy

One of the favourite strategies for option traders during anticipated high volatility is long straddles or strangles. The long straddle and long strangle strategies are popular as they focus on a big move regardless of the direction (up or down). A straddle trader will buy both a call and a put at the same strike price and expiration date. The trader expects that the underlying asset, be it a stock or a stock index, will move a lot but is unsure of its direction.

Since you are buying both a call and a put option, if the price of the stock or stock index moves far enough in either direction, you can make money from one of the options. The loss on the other option is limited to the premium you paid for it (See Payoff Diagram example of OKLI Straddle Strategy). For example, if you expect the result of an election will have a significant swing in prices but do not know who the eventual winner will be, the straddle would be a viable strategy to employ.

The strangle is similar to the straddle strategy, except the call and put in a strangle have different strike prices. The strangle is also slightly cheaper than a straddle because the strike prices are further from the current market price. The trade-off for more affordable costs for the strangles requires the price to move even further than a straddle. In a straddle, you break even sooner since the strike prices are at the current price level. However, you need a more significant move to break even in a strangle because the strike prices are further away (See Payoff Diagram example of OKLI Strangle Strategy).

Collars – Conservative Profits in Volatile Times

A collar strategy protects the investor from significant downside risk while limiting the upside potential. The primary objective of a collar is capital preservation, which makes it attractive to investors who want to reduce risk in their portfolio while still maintaining some exposure to potential gains in volatile market conditions.

The collar strategy combines holding a position, say in a futures contract, with a long put option and a short call option position. This combination protects against significant downside risk while capping potential upside gains in exchange for cost reduction.

For example, you take a long position on the FKLI at the current price of 1600. To protect the futures position, you will long the OKLI put option with the strike price below the current price, say 1500. You will also sell a call option above the current FKLI price of 1600, say 1700. You will collect the premium of the call to offset the cost of paying the premium for the put option.

Using this strategy, you can hedge their exposure to the stock index futures, manage risk during market downturns, and capture some gains if the market rises within a predefined range. (see Payoff Diagram example of OKLI Collar Strategy)

It is possible to design a collar at zero cost, where the cost of buying a put is fully offset by the premium received from selling a call. By doing that, the trader can establish the position without incurring any out-of-pocket costs.

Choose The Strategy to Fit

By choosing the suitable strategies above, traders can manage their exposure to risk and take advantage of the opportunities presented by market volatility. Every strategy comes with its risk-reward dynamics, so understanding the specific market conditions before executing it is essential.