Options are like a 3D chess game. The three dimensions are price of the underlying , time, and volatility.
The most misunderstood and neglected dimension, and often the last thing a novice trader learns about, is volatility. However, an options trader needs to understand volatility and appreciate its effects. No savvy trader ever buys or sells an option without awareness of the current volatility scenario.
Buying and selling volatility, Kevin Connolly - free download
Many sophisticated options traders go beyond that, choosing to focus on volatility as the main aspect of their trading while neutralizing the other factors. How do they do this, and why? The essence of volatility based trading, or V-trading for short, is buying options when they are cheap and selling options when they are dear.
The reason it's called volatility based trading comes from the way we measure cheapness or dearness — using a parameter called implied volatility or IV for short. We'll discuss IV in more detail below, but for now, it will suffice to say that high IV is synonymous with expensive options; low IV is synonymous with cheap options. Measuring premium levels is one thing; judging good trading opportunities is another.
There are two ways of judging the cheapness or dearness of options. The first is simply by comparing current IV with past levels of IV on the same underlying asset. The second is by comparing current implied volatility with the volatility of the underlying itself. Both approaches are important and come into play in all V-trading decisions. The most attractive opportunities are when options are cheap or dear by both measures.
The volatility trader typically uses puts and calls in combination, selecting the most appropriate strikes, durations, and quantities, to construct a position that is said to be "delta neutral". A delta neutral position has nearly zero exposure to small price changes in the underlying. Sometimes the trader has a directional opinion and deliberately biases his position in favor of the expected underlying trend. However, more often the V-trader is focused on making money just from volatility, and is not interested in trying to make money from underlying price changes.
Once a position is set up, it is simply held and then adjusted when necessary to re-establish the appropriate delta. These adjustments can be costly, in terms of transaction costs, and should be minimized, but not to the point where you expose yourself to too much delta risk. My rule is: "If you give the market a chance to take money away from you through delta , it will. Once option prices return to a more normal, average level as measured by IV , then the position can be closed. If not too many adjustments were required in the meantime, the trader should see a profit.
Since options are extremely sensitive to changes in implied volatility, trading options on the basis of volatility can be lucrative. Occasionally, options become way too expensive or way too cheap. In these situations the V-trader has a considerable edge. The investor can always count on volatility returning to normal levels after going to an extreme. This principle is called "the mean reversion tendency of volatility", and it is the foundation of volatility based trading. That volatilities "mean revert" is well established in many academic publications 1.
You can also see it for yourself just by looking at a few historical volatility charts. You will notice that when volatility goes to an extreme level, it always comes back to "normal". It may not happen right away. It may take anywhere from days to months, but sooner or later it always comes back. Implied volatilities seem to change from week to week, if not day to day. V-Traders find profit opportunities in this.
Others find these volatility changes a nuisance and a hazard. V-Trader or not, you need to pay attention to volatility. Since we measure how expensive or cheap options are using a parameter called implied volatility, or IV for short, it is important to understand IV. The term implied volatility comes from the fact that options imply the volatility of their underlying, just by their price. A computer model starts with the actual market price of an option, and measures IV by working the option fair value model backward, solving for volatility normally an input as if it were the unknown.
Actually, the fair value model cannot be worked backward, and has to be worked forward repeatedly through a series of intelligent guesses until the volatility is found that makes fair value equal to the market price of the option. The ERM crises in Britain in September caused the short-term interest rate market to increase in volatility dramatically. Although most individuals have a concept of what market volatility is.
Option School: What the Heck is "Selling Volatility"?
This book is devoted to explaining the concept of being able to buy or sell volatility and so it is important to be able to understand how it is measured. The strict definition of volatility as used by market participants is quite complex and involves the use of natural logarithms and a knowledge of the statistics associated with what is known as the lognormal distribution.
However, it is possible to understand volatility measurements using far simpler ideas and this is the approach we use here. Although the following examples are very simple it should be noted that these are just for exposition purposes only and the exact definition of volatility, if required, is given in most textbooks on option pricing.
It should also be noted that many market participants never have to go to the bother of actually calculating the volatility of a price series. Most of the information services such as Bloomberg and Reuters provide estimates of historic volatility and many provide excellent charts showing how the volatility of a given series has changed over time.
In addition to estimates of historic volatility these- services also provide information on what is known as the implied volatility. The implied volatility is probably one of the most important measures for the volatility player and will be dealt with later. The term "volatility of a price series" is really a misnomer. As with the concept of stock exposure, it is important to realise that the price of the stock under consideration is completely irrelevant; it is the change in the price that matters. As with many concepts in investment, it is not the price level that is important, it is the way the price is changing.
We can think of a series of price changes as being "caused" by time passing. In measuring volatility we are interested in the way in which the passing of time affects the price changes. A complication associated with looking at a series of prices and price changes is accounting for the presence of trend. Volatility is supposed to measure the degree of fluctuations, not the trend. If there is a trend then we need to look at the fluctuations around the trend. If the stock price is higher lower at the end of a period than at the beginning we say that there is positive negative trend.
Buying and selling volatility
This point is illustrated in the following specially contrived examples given in Figure 2. The numbers are chosen so that the series have identical trend. The second panel in Figure 2. It is clear that series II exhibits volatility and that series I does not. And that leads us on to a definition of volatility.
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The volatility of a price series is a measure of the deviation of price changes around the trend. Although this sounds complex it is really quite easy to calculate. The details of the calculations for series II are given in Table 2.
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Column c in Table 2. If these deviations are large we say that the series is very volatile, and if they are small we say the series is not very volatile. We need one descriptive statistic that will summarise the overall magnitude of the deviations and the most obvious one would be the average. So one cannot use the average.