Fed Rate Increase: How to Profit from Volatility?

Investors are expecting the Fed to increase interest rates multiple times this year. This can potentially increase the volatility in the markets.

Many investors are wondering how they can make bets in the market to profit from this volatility. In this article, we are going to talk about derivative contracts that can be used to build strategies to profit from volatility.

We are going to talk about: Straddle and strangle options positions, volatility index options and futures.

Straddle Strategy

In a straddle strategy, an investor purchases a call option and a put option on the same underlying asset with the same strike price and with the same maturity. The strategy enables the investor to profit from the underlying price change direction, thus the investor expects volatility to increase.

The strategy allows a long position to profit from any price change no matter if the price of the underlying is increasing or decreasing.

In order to profit from the strategy, the trader needs volatility to be high enough to cover the cost of the strategy, which is the sum of the premiums paid for the call and put options.

Strangle Strategy

A long straddle position is a little more costly due to the use of two at-the-money options. The cost of the position can be decreased by constructing option positions similar to a straddle but this time using out-of-the-money options. This position is called a “strangle” and includes an out-of-the-money call and an out-of-the-money put. Since the options are out of the money, this strategy will cost less than the straddle illustrated previously.

Even though this strategy does not require large investment compared to the straddle, it does require higher volatility to make money.

Volatility Index (VIX) Options and Futures

Volatility index futures and options are direct tools to trade volatility. VIX is the implied volatility estimated based on S&P500 option prices. VIX options and futures allow traders to profit from the change in volatility regardless of the underlying price direction.

These derivatives are traded on the Chicago Board Options Exchange (Cboe). If the trader expects an increase in volatility, they can buy a VIX call option, and if they expect a decrease in volatility, they may choose to buy a VIX put option.

Futures strategies on VIX will be similar to those on any other underlying. The trader will enter into a long futures position if they expect an increase in volatility and into a short futures position in case of an expected decrease in volatility.

Summary

The straddle position involves at-the-money call and put options, and the strangle position involves out-of-the-money call and put options. These can be constructed to benefit from increasing volatility. Volatility Index options and futures traded on the Cboe allow the traders to bet directly on the implied volatility, enabling traders to benefit from the change in volatility no matter the direction.