Trading Academy

Options and Volatility

by Nick Katiforis

Volatility is probably the most important principle of option trading, and the one least looked at and understood by the general public when trading options. Learning the correct use of this one principle alone can make a significant difference to your bottom line.

You would probably guess that a “volatile” market is one that is characterised by extreme price movements over time. However, you need to know exactly how much the price has moved, and over what period of time, for this information to be of any use in your trading. This statistical measure is known as historical volatility (also known as statistical volatility).

Historical Volatility helps you determine the possible magnitude of future moves of the underlying commodity. This information will influence the choice of trading strategy you will use.

Professional option traders generally do not concern themselves with the mathematical computations that go into the formula for computing historical volatility. Neither should you. The important thing is to use the information to help give you an edge when trading options.

Using Historical Volatility – An illustrated example

  • Price of underlying commodity = 100
  • Historical Volatility = 10%

Figure 1

Historical volatility is expressed as an annualised figure. The 10% figure referred to in Figure 1 means that there is a 68% chance (1 standard deviation) that the price of the underlying commodity (currently at 100) will, within one year, trade between 90 and 110 (10% either side of 100).

Another example may help:

  • Gold is trading at $300 per ounce.
  • Historical volatility is 20%.

Figure 2

The volatility of 20% referred to in figure 2, means that Gold will have a high probability (68%) of trading between $240 and $360 (20% either side of $300) over a 1-year period.

If you thought the price of gold was going up and you wanted to buy a gold call option, which option exercise price would you pick? Knowing the historical volatility of gold could help you decide.

By looking at the above distribution of prices it shows that prices above $360 and below $240 have a much lower probability of being reached. This means a call option with an exercise price higher than $360 will have a much smaller probability of becoming profitable.

This information can help you determine which exercise price is most appropriate to choose for the particular strategy you have in mind. Of course these figures should only be used as a guide only, as severely trending markets can carry prices to extreme levels in the commodity markets from time to time.

From the above examples it may become apparent that the higher the historical volatility figure, the greater the price range of movement a commodity can be expected to make. Conversely, the lower the volatility, the smaller the trading range is likely to be for the underlying commodity.

But Wait, There’s More!

Whereas historical volatility is a measure of volatility that looks back in time to show how volatile the market has been, there is another measure of volatility that looks forward in time to gauge where historical volatility will be in the future. This measure of volatility is known as implied volatility. This is even more important to an options trader than historical volatility.

Implied Volatility

Apart from changes in the price of the actual underlying commodity or security, the price of an option is most affected by changes in implied volatility. It measures what option traders expect the historical volatility will be in the future. The actual option price will determine implied volatility. The volatility is implicit in the price of the option.

Implied volatility is an indicator of the current sentiment of the market. This sentiment will be reflected in the price of the options.

The Property Market – An Analogy

In the property market, the best buying opportunities usually present themselves when sentiment in the property market is flat and the expectation is that property prices will remain stagnant or even go lower. At these times property prices are said to be ‘cheap’.

By buying when property prices are ‘cheap’ and waiting for the time when the sentiment of the market is running ‘hot’, you can then sell your property when prices are ‘expensive’ and turn a handsome profit.

This same principle can be applied to options, using implied volatility as an indicator of market sentiment. Buy when implied volatility is low (flat sentiment) and sell when implied volatility is high (extreme bullish or bearish sentiment).

If sentiment in the crude oil market becomes bullish, the prices of crude oil call options will rise even before the actual price of crude oil does.

High-implied volatility means that sentiment is extremely bullish or bearish and that option traders believe there is a greater likelihood of higher or lower prices being reached in the future.

Therefore:

  • Option buyers will be prepared to pay more for the option as they think there is a greater chance of the market making a large move in their favour.
  • Option writers (sellers) will incur a potentially greater risk if the expected price range increases and will therefore demand a higher premium for writing options.

These circumstances lead to option prices becoming more expensive when volatility is high, and less expensive when volatility is lower.

Options that have high implied volatility compared to their past are called ‘expensive’. Options that have low implied volatility compared to their past are said to be ‘cheap’.

Your job as an options trader is to take advantage of the times when sentiment swings to extremes by instituting selling strategies when options are ‘expensive’ and buying strategies when options are ‘cheap’. The sentiment of the market will over time usually return to a ‘normal’ level somewhere in between. By doing this you gain a ‘trading edge’.

Strategy

  • Look at instituting option buying strategies when implied volatility is at the low end of its historical range.
  • Look at instituting option writing (selling) strategies when implied volatility is at the high end of its historical range.

The first thing a professional options trader will do before initiating any trade is to check his volatility charts, to establish if volatility is relatively high or low compared to where it has been over the last few years, and over the last few months. This is to gauge whether buying or writing strategies are most appropriate.

Figure 3

Illustrated in Figure 3 is a price and volatility chart of gold. Option buying strategies would have been appropriate to institute when volatility was low, before the breakout in September. If the underlying market does make a sharp move in your favour:

1. The value of the option increases as the price of the underlying commodity increases (eg if gold goes up, call options will generally increase in value).

2. Volatility may rise significantly, driving the price of options higher (remember, higher volatility = higher option prices).

As an added bonus, if the market fails to make a big move, the potential loss should be lower as you would have paid less for the option you bought due to the low implied volatility.

Trading Tip

Large, explosive moves are often preceded by periods of low volatility. It is therefore a good time to initiate option buying strategies when volatility is at the low end of its historic range. In this situation buy options with plenty of time left to expiry because you never know just when volatility will break out. Give yourself time for the trade to work in your favour.

In September 1999 (see figure 3) both the price and volatility of gold exploded upwards. With volatility high, option-writing strategies were more appropriate to take advantage of the spike up in the price of gold options.

There are two reasons for this:

1. Firstly, you will receive more money for writing the option (remember high implied volatility = high option prices).

2. Secondly, if volatility is already at high levels compared to its historical range, there is statistically less chance of it going significantly higher. It is more likely to revert back to its ‘normal’ level over time.

Trading Tip

It is generally not appropriate to buy options during periods of high volatility. Both the high cost of the option and time decay are working against you. An out-of-the-money option, bought when volatility is high, requires a big price move in the underlying commodity in your favour, before expiry, to be profitable.

The same option bought when volatility is lower would firstly cost less, and secondly require a smaller move in the underlying market to become profitable. The option buyer will also benefit from any sudden rise in implied volatility as the option held becomes more expensive.

Just as it is not appropriate to buy options when volatility is high, it is also not appropriate to write options if volatility is at low levels compared to its historic range.

A sharp increase in volatility such as the one that occurred in the gold market in September 1999 (Figure 3) could see option premiums driven to extremely high levels. If you had written options when volatility was low and were forced to buy these options back after volatility exploded upwards, you could lose a lot more than you anticipated.

This situation may happen infrequently, but when it does happen, it can cause much grief to option writers who write options when volatility is low compared to its historical range.

Trading Tip

Option writing strategies should be initiated when implied volatility is high and near the top end of its historical range. Firstly, you can receive more money than if implied volatility was low (high option volatility = high option prices). Secondly, you can write ‘expensive’ options with exercise prices a long way from the current market price, with a much smaller probability of ever being reached.

An Example of an Option Writing Strategy

In late November 2000 a trade was recommended to clients in sugar. The trade was to write a put option and a call option. This strategy is known as a Written Strangle (also called a sold strangle).

Figure 4

Figure 4 shows how the strangle works. We are effectively trying to ‘strangle’ the market between the two prices (8 and 11.50) where we have written the options. We received a gross credit of USD$537.6. If the price of sugar stays between these two points at the expiry of the options, then you keep the whole premium. This is exactly what happened in this trade. The price of sugar finished between 8 and 11.50 and therefore the clients kept the premium.

In this example implied volatility was at a relatively high level compared to its historic range when we implemented the strategy. This meant that we were able to get a good premium for writing the options that were a good distance from where the current price of sugar was. Within a short period of time volatility declined. Both the 11.50 call option and 8.00 put option both lost value, which was beneficial for the strategy. This is a good example of a non-directional trading strategy that is only available to option traders.

Volatility Summary

  • Historical volatility is a measure of the probability of a market holding a given trading range over a period of time.
  • Historic volatility is based on the movement of the underlying market (eg gold).
  • Implied volatility is what option traders expect historical volatility will be in the future.
  • Low implied volatility = low option prices.
  • High implied volatility = high option prices.
  • Extreme bullish or bearish sentiment means higher implied option volatility, which also means higher option prices.
  • Flat sentiment found in range-bound and quiet markets will mean low implied option volatility and therefore lower option prices.