At certain times an option can become more ‘expensive’ relative to another option that’s trading in the same commodity but with a different exercise price. This presents an opportunity to gain a ‘trading edge’. How? By buying the more fairly priced option and selling the more ‘expensive’ option.
How can you tell if options are overpriced compared to other options?
The answer is by using implied volatility as a measure to compare different options – high implied volatility = higher option prices. Therefore, if one option has a significantly higher implied volatility than another, it means it is ‘relatively’ more ‘expensive’ than the other option. When this situation occurs it is called a volatility skew.
If there is a significant difference between the implied volatility of two similar options, then sell the overpriced option and buy the more fairly priced option. This helps to tilt the odds more in your favour, giving you a trading edge.
An Example of a Volatility Skew in Gold
Volatility levels can vary between different option exercise prices. Take the following example:
- An August gold call option, with an exercise price of $300, may be trading at an implied volatility level of 20%.
- An August gold call option with an exercise price of $330 may have a volatility level of 30%.
The $330 Calls are trading at a 50% higher volatility level than the $300 calls (30% vs 20%), making them relatively more ‘expensive’ than the closer-to-the-money calls. This is an example of a volatility skew (implied volatility is skewed toward the higher exercise price.)
The above example looks at an option volatility skew between options that expire in the same month (April), but with different exercise prices ($300 and $330).
You can also find volatility skews between options with different expiry months. For example, June gold call options may have a higher volatility level (relatively more expensive) than August gold call options.
You can construct a trade (calendar spread) to take advantage of this volatility skew in options with different expiry months to help improve your odds of success and give you a trading edge.
The principle remains the same as previously stated:
Buy an option in the month with the lower implied volatility and sell an option in the month with the higher implied volatility.
Why Does This Volatility Skew Exist?
Why should options on the same underlying commodity trade at different volatility levels? One reason is human nature. If a market that has been very quiet all of a sudden comes alive and starts making big moves, most likely you will see option volatility rise. However, it may not rise evenly over all the different exercise prices, or contract expiry months of an option.
Option traders will look to profit from this big move by buying options. Unsophisticated traders will look to buy the cheapest options available in order to give themselves more leverage. What they are effectively looking for is a lottery ticket; to outlay a small amount that will pay a lot. This requires a big move in the underlying commodity.
The demand for these ‘cheap’ out of the money options, effectively drives up their price (and implied volatility), making them relatively more expensive compared to the options trading closer to where the market finds itself currently (at the money options). Although these out of the money options are still cheaper than the at the money options, they are relatively more expensive compared to their chance of becoming profitable.
This is the main reason why most unsophisticated options traders lose money when trading options. They look to buy ‘cheap’, out of the money, overvalued options, with little chance of ever becoming profitable. Their only consolation is that they may not lose a lot of money. The analogy is similar to that of buying a lottery ticket.
Avoid buying ‘cheap’ out of the money options when implied volatility is high, especially if there is little time left to expiry. The odds of making money on this sort of trade are very low.
To make money you firstly need to pick the right market direction. Then you need the market to make a sizeable move. And finally you need this to happen in a relatively short period of time, before expiry of the option. If any of these factors are absent then you will lose money on the trade, without ever having had much chance of making money in the first place. There is a better way…
Trading with an Edge
Rather than buying a lottery ticket, there is a way to construct a trade to take advantage of a particular view you may have of the market. That is to look for a situation where there is a disparity in the price of options (a volatility skew where one option strike price has a significantly higher volatility than another). This will help give you a trading edge.
Buy the more fairly priced option, at the same time sell the most overvalued option. There are two reasons why you would do this:
- Firstly, you are buying an option that will be closer to where the market currently finds itself. The market doesn’t need to make as big a move in order for your trade to be profitable.
- Secondly, you are offsetting part of the cost of buying that option by selling an out-of-the-money ‘expensive’ option and in the process lowering your overall risk.
What you are giving up is the potential (regardless of how small the odds) of making unlimited profit. Your maximum profit is the difference between the exercise price of the bought option and the sold option, less what you paid for the option.
Option Spread Trading
Anytime you use two or more options to form a trading strategy, it is called a spread trade. The spread trade illustrated on the previous page is called a bull call spread. This is one of the most common types of option spread trades. It is employed when your view of the market is bullish (market going up), and you wish to limit your risk even further.
You would buy a call option and at the same time sell a higher exercise price call option. This lowers the overall cost of the trade because you receive money for selling an option, which partly offsets the cost of the option you bought.
An Example of a Bull Call Spread
In early February 2000 there existed a volatility skew between the 525 May silver call options and the May 600 silver call options.
525 silver call implied volatility = 19%
600 silver call implied volatility = 27%
This shows 600 silver call options are relatively more expensive than the 525 silver calls which means an edge can be gained by buying the fairer priced option (lower implied volatility) and at the same time selling the overpriced option (higher implied volatility).
Silver trades in cents per ounce. One cent = US$50
At the time the price of silver was approximately 530 cents.
If you believed that the silver market was going up, rather than just buying a call option, you could have entered a bull call spread.
You would buy the more fairly priced 525 call option for 19 cents ($950) and sell the relatively overpriced 600 cent call for 5 cents ($250) (see Figure 1). This would lower the overall cost of the trade while still allowing you a good profit potential. In this case it would be the difference between 525 and 600 which is 75 cents or $3,750. Less what you paid for the option (19c – 5c = 14c or $700), this would work out to a potential maximum profit of $3075.
The limitation of entering a bull call spread rather than buying an outright call option is that you give up the potential for unlimited profits. If the silver market went to 800 cents your maximum profit would be capped at 600 cents. However the probability of such a large move occurring is very low.
In the above trade the initial rally in the price of silver could not be sustained. The market traded lower thereafter. In this case the bull call spread would see you lose less money if the market went against you than if you had only bought the 525 call option alone. This is the major benefit of using a bull call spread as opposed to buying a call option alone.
When initiating a bull call spread, take profits when the spread reaches approximately 2/3 of the total maximum value of the spread. This means if the total potential profit on the spread is $3000, then take profits if the spread’s value reaches $2,000. The risk/reward ratio in going for the extra third is too high to be worthwhile.
Option Mispricing Summary
- At certain times options can become overpriced compared to other similar options.
- Use implied volatility as a measure to find pricing disparities between different options then buy the more fairly priced option and sell the ‘overpriced’ option.
- A ‘volatility skew’ occurs when one option is relatively more expensive compared to another with a different exercise price or expiry month.
- A bull call spread involves simultaneously buying and selling options with different exercise prices.
- Bull call spreads lower your overall risk by reducing the cost of the trade, but also limit your potential profit.