Strategies for Trading Volatility With Options

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Strategies for Trading Volatility With Options

There are seven factors or variables that determine the price of an option. Of these seven variables, six have known values, and there is no ambiguity about their input values into an option pricing model. But the seventh variable—volatility—is only an estimate, and for this reason, it is the most important factor in determining the price of an option.

  • The underlying’s current price – known
  • Strike price – known
  • Option type (Call or Put) – known
  • Time till the option expires – known
  • The risk-free interest rate is well-known.
  • Dividends on the underlying – known as dividends
  • Volatility – unknown

Key Takeaways

  • Options pricing are heavily influenced by the underlying asset’s expected future volatility.
  • As a consequence, even if all of the other factors influencing an option’s price are known, people’s predictions of volatility will differ.
  • Trading volatility therefore becomes an important set of methods utilized by options traders.

Historical vs. Implied Volatility

Volatility can either be historical or implied; both are expressed on an annualized basis in percentage terms. Historical volatility (HV) is the actual volatility demonstrated by the underlying over a period of time, such as the past month or year. Implied volatility (IV), on the other hand, is the level of volatility of the underlying that is implied by the current option price.

Implied volatility is far more relevant than historical volatility for options’ pricing because it looks forward. Think of implied volatility as peering through a somewhat murky windshield, while historical volatility is like looking into the rearview mirror. While the levels of historical and implied volatility for a specific stock or asset can be and often are very different, it makes intuitive sense that historical volatility can be an important determinant of implied volatility, just as the road traversed can give one an idea of what lies ahead.

All else being equal, an elevated level of implied volatility will result in a higher option price, while a depressed level of implied volatility will result in a lower option price. For example, volatility typically spikes around the time a company reports earnings. Thus, the implied volatility priced in by traders for this company’s options around “earnings season” will generally be significantly higher than volatility estimates during calmer times.

Volatility, Vega, and More

The “Option Greek” that measures an option’s price sensitivity to implied volatility is known as Vega. Vega expresses the price change of an option for every 1% change in volatility of the underlying.

Two points should be noted with regard to volatility:

  • In the options market, relative volatility might help you avoid comparing apples to oranges. Relative volatility compares the volatility of a stock now to its volatility over a period of time. Assume that stock A’s one-month at-the-money options have previously had an implied volatility of 10%, but are now exhibiting an IV of 20%, whereas stock B’s one-month at-the-money options have historically had an IV of 30%, but have recently climbed to 35%. Although stock B has more absolute volatility, it is clear that A has seen a larger shift in relative volatility.
  • When analyzing the volatility of an individual stock, it is equally crucial to examine the general degree of volatility in the market. The Cboe Volatility Index (VIX), which measures the volatility of the S&P 500, is the most well-known indicator of market volatility. When the S&P 500 falls suddenly, the VIX, often known as the fear gauge, increases rapidly; conversely, when the S&P 500 climbs smoothly, the VIX falls.
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The most fundamental principle of investing is buying low and selling high, and trading options is no different. So option traders will typically sell (or write) options when implied volatility is high because this is akin to selling or “going short” on volatility. Likewise, when implied volatility is low, options traders will buy options or “go long” on volatility.

Based on this discussion, here are five options strategies used by traders to trade volatility, ranked in order of increasing complexity. To illustrate the concepts, we’ll look at a historical example using Netflix Inc.(NFLX) options.

Buy (or Go Long) Puts

When volatility is high, both in terms of the broad market and in relative terms for a specific stock, traders who are bearish on the stock may buy puts on it based on the twin premises of “buy high, sell higher,” and “the trend is your friend.”

For example, Netflix closed at $91.15 on Jan. 27, 2016, a 20% decline year-to-date, after more than doubling in 2015, when it was the best performing stock in the S&P 500. Say that traders who were bearish on the stock could buy a $90 put (i.e. strike price of $90) on the stock expiring in June 2016. The implied volatility of this put was 53% on Jan. 29, 2016, and it was offered at $11.40. This means that Netflix would have had to decline by $12.55 or 14% from those starting levels before the put position became profitable.

This strategy is a simple but relatively expensive one, so traders who want to reduce the cost of their long put position can either buy a further out-of-the-money put or can defray the cost of the long put position by adding a short put position at a lower price, a strategy known as a bear put spread.

Continuing with the Netflix example, a trader could have bought a June $80 put at $7.15, which was $4.25 or 37% cheaper than the $90 put at the time. Or else the trader could have looked to a bear put spread by buying the $90 put at $11.40 and selling (writing) the $80 put at $6.75 (note that the bid-ask for the June $80 put was thus $6.75 / $7.15), for a net cost of $4.65.

Write (or Short) Calls

A trader who was also bearish on the stock but thought the level of implied volatility for the June options could recede might have considered writing naked calls on Netflix in order to pocket a premium of over $12. Assume that the June $90 calls had a bid-ask of $12.35/$12.80 on Jan. 29, 2016, so writing these calls would result in the trader receiving a premium of $12.35 (i.e. receiving the bid price) (i.e. receiving the bid price).

If the stock closed at or below $90 by the expiry date of those calls on June 17, the trader would have pocketed the whole premium earned. If the stock finished at $95 shortly before expiry, the $90 calls would have been worth $5, resulting in a net gain of $7.35 (i.e. $12.35 – $5).

The Vega on the June $90 options was 0.2216, so if the IV of 54% fell abruptly to 40% (i.e., 14 vols) shortly after the short call position was opened, the option price would have fallen by around $3.10. (i.e. 14 x 0.2216).

It is important to note that writing or shorting a naked call is a dangerous strategy due to the potentially infinite risk if the underlying stock or asset appreciates in value. What if Netflix rose to $150 before the $90 naked call position expires in June? In that situation, the $90 call would have been valued at least $60, resulting in a 385% loss for the trader. To reduce this risk, traders would often combine a short call position with a long call position at a higher price in a method called as a bear call spread.

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Short Straddles or Strangles

The trader writes or sells a call and a put at the same strike price in order to collect premiums on both the short call and short put positions in a straddle. The trader anticipates IV to fall dramatically by option expiration, enabling most, if not all, of the premium paid on the short put and short call positions to be kept.

Using Netflix as an example, writing the June $90 call and the June $90 put would have resulted in a trader getting an option premium of $12.35 + $11.10 = $23.45. The trader was betting that the stock would remain close to the $90 strike price by the time the options expired in June.

Writing a short put obligates the trader to purchase the underlying at the strike price even if it falls to zero, but writing a short call has potentially infinite risk, as previously stated. However, dependent on the size of the premium earned, the trader has some margin of safety.

In this case, the approach would have been successful if the underlying Netflix stock ended above $66.55 (i.e. strike price of $90 – premium received of $23.45) or below $113.45 (i.e. $90 + $23.45) before option expiration in June. The precise amount of profitability was determined by where the stock price was at the time of option expiry; profitability was greatest at a stock price by expiration of $90 and decreased as the stock moved away from that level. The approach would have been unprofitable if the stock had closed below $66.55 or above $113.45 by option expiration. Thus, the break-even marks for this short straddle strategy were $66.55 and $113.45.

The distinction between a short strangle and a short straddle is that the strike prices on the short put and short call contracts are not the same. In general, the call strike is higher than the put strike, and both are out-of-the-money and about equidistant from the underlying’s current price. With Netflix trading at $91.15, the trader could have written a June $80 put at $6.75 and a June $100 call at $8.20, netting a $14.95 premium (i.e. $6.75 + $8.20). The danger of this method was lessened to some degree in exchange for earning a lesser amount of premium. This is because the strategy’s break-even points increased to $65.05 ($80 – $14.95) and $114.95 ($100 + $14.95), respectively.

Ratio Writing

Simply put, ratio writing implies writing more alternatives than are bought. The most basic method employs a 2:1 ratio, with two options sold or written for every one acquired. The aim is to profit from a significant drop in implied volatility before option expiry.

Using this method, a trader might have acquired a Netflix June $90 call for $12.80 and written (or shorted) two $100 calls for $8.20 apiece. In this scenario, the net premium received was $3.60 (i.e. $8.20 x 2 – $12.80). A bull call spread (long June $90 call + short June $100 call) with a short call (June $100 call) is equal to this approach. The biggest profit from this technique would be realized if the underlying stock closed precisely at $100 before the option expired. The $90 long call would have been worth $10 in this situation, but the two $100 short calls would have expired worthless. The maximum gain would therefore be $10 + $3.60 premium collected = $13.60.

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Ratio Writing Benefits and Risks

Let’s look at several situations to see how profitable or risky this technique is. What if the stock closed at $95 at the time the options expired? The $90 long call would have been worth $5 in this situation, but the two $100 short calls would have expired worthless. The total gain would have been $8.60 ($5 + $3.60 net premium received). If the stock closed at $90 or lower at option expiration, all three calls would have expired worthless, and the sole gain would have been the $3.60 net premium received.

What if the stock closed over $100 at the time the options expired? The loss on the two short $100 calls would have diminished the gain on the $90 long call in this scenario. At a stock price of $105, the entire profit/loss would have been: $15 – (2 X $5) + $3.60 = $8.60.

The P/L for this strategy would be: (profit on long $90 call + $3.60 net premium received) – (loss on two short $100 calls) = ($23.60 + $3.60) – (2 X 13.60) = 0. As a result, if the price increased over the break-even mark of $113.60, the approach would become progressively unprofitable.

Iron Condors

In an iron condor strategy, the trader combines a bear call spread with a bull put spread of the same expiry, intending to profit from a drop in volatility that results in the stock trading in a tight range throughout the options’ life.

The iron condor is built by selling an out-of-the-money (OTM) call and purchasing another call with a higher strike price, while selling an ITM put and buying another put with a lower strike price. In general, the difference between call and put strike prices is the same, and they are equidistant from the underlying. Using Netflix June option pricing, an iron condor may include selling the $95 call and purchasing the $100 call for a net credit (or premium received) of $1.45, while concurrently selling the $85 put and buying the $80 put for a net credit of $1.65 (i.e. $8.80 – $7.15). As a result, the total credit earned would be $3.10.

The maximum profit from this technique was equal to the net premium earned ($3.10) if the stock closed between $85 and $95 at option expiration. The biggest loss would come if the stock was trading above the $100 call strike or below the $80 put strike at expiry. The maximum loss in this situation would be equal to the difference between the strike prices of the calls and puts, minus the net premium received, or $1.90 (i.e. $5 – $3.10). The iron condor has a somewhat modest reward, but the possible loss is also rather restricted.

The Bottom Line

Traders employ these five tactics to profit from stocks or assets with significant volatility. Because most of these techniques entail potentially limitless losses or are highly sophisticated (such as the iron condor approach), they should only be utilized by experienced options traders who understand the hazards of options trading. Beginners should just purchase basic vanilla calls or puts.

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