Volatility is a statistical calculation measuring the dispersion of returns (usually logarithmic) for an asset or market index over a period of time. A higher number indicates greater uncertainty in establishing a consistent price for the asset and thus indicates higher risk. A lower number suggests the asset does not change in value particularly rapidly and is thus seen as a safer investment. The measure can refer to either the standard deviation or variance of returns from that same asset or market index. In finance, it is represented by the Greek symbol “σ”.
Traders often refer to two types of volatility. Historic volatility measures a time series of past market prices between two specified dates. Implied volatility, is a forward looking measure, and is derived from the market price of a derivative contract, usually options. That is, the value is implied, as it is the unknown quantity when having been given the option price (as quoted in the market). For more on this topic see Kevin Connolly’s book Buying and Selling Volatility.
Merger Arbitrage Volatility Example
In addition to trading options within a merger arbitrage strategy, profits can also be made from the volatility of the spread itself. Many traders know that despite being associated with riskier investments, volatility may actually provide a range of potentially profitable opportunities for the observant investor. Merger Arbitrage Limited frequently refers to the “Active Arbitrage” strategy. This is where a merger arbitrage spread exhibits an unusually high level of movement, possibly as a result of a hostile takeover. This additional movement creates opportunities to trade the stock back and forth to increase returns before the deal nears consummation. An example of this strategy is used to trade the Red Robin Gourmet Burgers (RRGB) merger spread.
Additional Resources
There are many more facets to understanding and trading volatility. Event driven investment strategies are seen as a way to lower the volatility of an overall portfolio of investments. Products such as Exchange Traded Funds (ETF’s) (VIX) and volatility swaps are often used to increase AND decrease risk. Additional calculations such as annualized figure are commonplace in the finance industry. Traders are STRONGLY advised to research this area further as required. To get you started, we provide a link to an appropriate list of books on Amazon.
