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How To Trade Volatility: Ultimate Guide for 2024

Options Trading 101 - The Ultimate Beginners Guide To Options

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by Gavin

When trading options, one of the hardest concepts for beginner traders to learn is volatility, and specifically how to trade volatility.

After receiving numerous emails from people regarding this topic, I wanted to take an in depth look at option volatility.

Introduction

Tired of guessing the direction of your stock wrong?

Losing money on your options positions despite being correct in your directional assumption?

Maybe volatility trading is for you!

Catchy slogans aside, trading volatility may not be as glamorous as other trading paths.

After all, the average person cannot list any famous volatility traders.

Despite this the options market is steadily growing and therefore volatility is becoming ever more important.

Trading volatility can also be extremely rewarding, so let’s learn a few ways how to trade it.

What is Volatility?

Volatility is the statistical measure of dispersion of returns in a stock or index. Or keeping it simple it is how much an asset will move.

In the options world how much, the market thinks an asset will move is shown by its implied volatility. When an individual trades volatility they are usually expressing one of two views.

1. Volatility is either overpriced, meaning they think the stock will move less than the market implies.
2. Volatility is under-priced, implying they think stock will move more than the market implies.

Here is a theoretical example to demonstrate the idea.

Let’s look at a stock priced at 50. Consider a 6-month call option with a strike price of 50:

If the implied volatility is 90, the option price is \$12.50

If the implied volatility is 50, the option price is \$7.25

When implied volatility is 30, the option price is \$4.50

This shows you that, the higher the implied volatility, the higher the option price.

Historical Volatility and Implied Volatility

We know historical volatility is calculated by measuring the stocks past price movements.

It is a known figure as it is based on past data.

I want go into the details of how to calculate HV, as it is very easy to do in excel.

The data is readily available for you in any case, so you generally will not need to calculate it yourself.

The main point you need to know here is that, in general stocks that have had large price swings in the past will have high levels of Historical Volatility.

As options traders, we are more interested in how volatile a stock is likely to be during the duration of our trade.

Historical Volatility will give some guide to how volatile a stock is, but that is no way to predict future volatility.

The best we can do is estimate it and this is where Implied Vol comes in.

Implied Volatility

Implied volatility is an estimate, made by professional traders and market makers of the future volatility of a stock. It is a key input in options pricing models.

Implied Volatility takes into account any events that are known to be occurring during the lifetime of the option that may have a significant impact on the price of the underlying stock.

This could include and earnings announcement or the release of drug trial results for a pharmaceutical company.

The current state of the general market is also incorporated in Implied Vol.

If markets are calm, volatility estimates are low, but during times of market stress volatility estimates will be raised.

The Black Scholes Model

The Black Scholes model is the most popular pricing model, and while I won’t go into the calculation in detail here, it is based on certain inputs.

Volatility is the most subjective (as future volatility cannot be known) and therefore, gives us the greatest chance to exploit our view of Vega compared to other traders.

One very simple way to keep an eye on the general market levels of volatility is to monitor the VIX Index.

Let’s explore a few ways to express our view on volatility using options.

The short straddle allows an investor to express the view that volatility is overpriced.

A short straddle is created by selling at at-the-money put and call with the same expiration.

The corresponding structure will profit if the stock stays within a range equal to the credit received when the straddle is sold.

The long straddle allows an investor to express the view that volatility is under-priced.

A long straddle is simply the opposite of the short straddle and is created by buying an at-the-money put and call.

We can see that the corresponding structure will profit from large moves in either direction.

Conversely it will lose money if the stock does not move more than the market implies.

A note for simplicity. There are multiple options structures aside from straddles that can express a short or long volatility view.

Some of these are strangles and iron condors to name a few.

While these are different structures the view being expressed is virtually the same and volatility will affect them in very similar ways.

So How Does Volatility Affect These Positions?

Let’s go back to the short straddle.

Our purple line shows the current P&L.

Naturally when we first place the trade our P&L is at zero (yellow circle).

As time passes the purple line will move closer to the blue line.

Therefore, if the stock does not move at all from its current position of \$420 at expiration, we would reach full profit (green circle).

If this occurs theta, or time decay was greater than gamma, or price movement.

Sounds like easy money! Except stocks do move. Alternatively imagine we have a large realized move.

The stock is now trading at \$405. We can see (red circle) that we now have significant losses.

At the red circle gamma was greater than theta, or volatility was under-priced.

At the red circle the position loses a lot of its short volatility profile and becomes almost like long stock.

Therefore, if the investor does not have an opinion on the price of the stock (or delta), they should adjust or close the position.

This is showing implied vs realized volatility in effect.

Now let us look at what happens if the level of implied volatility changes.

Imagine the same trade above but in this example after placing the trade with our opinion that volatility is overpriced the market agrees with us.

This causes volatility to go down 5%.

Volatility Down 5%

We can see that the purple line has converged upon the blue line.

We have also made \$10,000. Despite this no time has passed.

What has happened is that future expectations for volatility are now lower therefore the future expected range of the stock is also lower.

We have taken advantage of the level of implied volatility, or vega.

At this point we could simply close out the trade or if we still believe volatility is overpriced stay in the trade till these two lines converge.

Another product that allows investors to trade volatility are VIX Futures or the VXX.

The VIX index is a volatility-based index that is calculated using a basket of S&P 500 options.

The VIX itself cannot be directly traded but investors can trade either VIX Futures or the VXX (an ETN that purchases VIX futures).

Expressing a view that market volatility is under-priced is as simple as selling a VIX future, and if market volatility is overpriced buying one.

The advantage of the trading VIX futures is that they are a pure play on volatility.

Over the life of the contract there is no directional view taken by the investor.

Hence no “delta hedging” is needed although positions will need to be managed for risk.

Many investors like trading options on the VIX Futures and VXX.

One important note.

As these products are already volatility products trading options on them is actually trading the volatility of volatility.

Trading Volatility With a Directional View

While these are a few ways to trade volatility with no view on direction we can always trade volatility with a directional view as well.

In fact, if you are trading options in any capacity, you are most likely taking a view on volatility.

For example, imagine we think stock A is under-priced and we also believe volatility is under-priced. In this example simply buying a call option expresses our view perfectly.

If you are able to express both a directional and volatility view correctly you will get rewarded big time for being correct.

Some investors are befuddled when.

They are unaware that while they were right on direction, they were wrong on volatility.

If an investor does not understand how to trade volatility or have a view on it, simply trade the stock, not the options.

Concluding Remarks

Volatility is all around us. Options themselves are both price and volatility products.

Options allow an investor to trade exclusively volatility, without being necessarily concerned about the direction of the underlying.

Products such as the VIX futures also allow expression of a view on market volatility, simply and easily.