Buying and Selling Volatility, Part I
Options are like a 3-D 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, the 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.
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. When options are cheap or dear by both measures, these are attractive opportunities indeed.
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 held, and adjusted at times 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, then the position can be closed. If not many adjustments were required in the meantime, the trader should see a profit.
Since options are extremely sensitive to 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 academic writings.1 Besides that, you can 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.” Sometimes it doesn’t 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.
1 “Mean reversion in stock market volatility,” Michael Dueker, 1994; “A panel data test for mean reversion using randomization”, H. Schaller, 1993; “Long-term equity anticipation securities and stock market volatility dynamics”, T. Bollerslev, 1996; “How to tell if options are cheap,” Galen Burghardt and Morton Lane, 1990.
Click here to go to Part II.