In recent days, financial markets around the world have seen much turmoil, and market indices have dropped dramatically. Many wonder how long the ‘correction’ will last or whether this is the start of another bear market. While stock investors are understandably worried, such market uncertainty is what options traders live for. Increase in volatility of the markets means more opportunity to make money – especially for the savvy options trader. Falling markets are generally associated with an increase in volatility. It is said that the bull takes the stairs up, and the bears the elevator down – implying that stocks and markets generally fall faster than they rise.
US Markets Drop Yet Again
Firstly, it is important to understand how volatility influences options pricing to be able to understand why increase in volatility is a ‘gift’ to the options trader. To understand how volatility affects options prices, one needs to at least know about the Black-Sholes formula, a common model used to calculate options prices. Fortunately, one does not need to know how to do the calculations as all brokerages nowadays use computers that do the calculations automatically based on certain inputs from the market makers.
Secondly, it is also important to distinguish between historical volatility (what the market or stock has done in the past) and implied volatility (IV, what is implied by the options pricing model). A quick analysis of what has happened in the past can help one decide what might happen in the future – although, there is no guarantee that history will repeat itself. A rise in implied volatility without a corresponding increase in real (historical) volatility is good news for the options trader, as it allows him/her to be more creative in trading .
In brief, options prices are determined by the following main factors:
- Current price of the underlying stock or index
- Strike price of the option
- Time until expiration
- Risk-free interest rate
- Implied volatility
As one can see from the above list, of all the factors, the only one that is ‘nebulous’ is implied volatility. In reality, the implied volatility is a term that is derived to explain option prices. Although at the start of a trading day, market makers can input a given implied volatility into their calculations to set options prices, during the trading day, the options prices are set by the market forces – what folks are willing to pay for a given option. Traders who recognize that option prices imply a certain volatility of the underlying stock or index can profit immensely, as people are terrible at predicting the future, and the volatility implied by the option prices rarely comes to pass.
UNDERSTANDING AND PROFITING FROM IMPLIED VOLATILITY
To profit from changes in implied volatility, one needs to understand some basic thoughts. Let’s review them below …
- It is vital to know how high implied volatility is currently compared to where it was in the past. For example, see graph of VIX below
- Effects of IV are greatest at the ‘at the money’ (ATM) strike, and less so further away from the ATM strike forming what is known as the ‘bell-shaped’ curve of a ‘normal’ distribution.
- Effects of IV are greater on options with more time until expiration, as ‘Vega’, which quantifies the effects of IV on the options, is higher in longer term options and lower in shorter term options.
- The effects of IV can be minimized by combining both long and short options in a single trade, such as in a spread or condor.
VIX spikes to record levels
Since a high implied volatility implies that the stock or index will move a lot, some option traders might choose to play delta-neutral plays such as straddles or strangles, trades that profit if the underlying moves – in any direction. High volatility, especially intra-day volatility or short-term volatility, can also allow the options trader to ‘lock in profits’ by use of strategically placed GTC orders at pre-determined targets.
Since high implied volatility ‘pumps up’ option prices, traders who love theta-positive trades like credit spreads or iron condors like increases in implied volatility as it allows them to place their trades further away from the underlying (and profit when IV drops back to normal values).
Since IV has jumped to its highest levels in the past year (see graph above), the current markets are an options trader’s playground! Caveat Emptor! Do not place trades you do not understand, as high volatility also means it is easier to lose money as it is to profit. Until next time …
Happy Trading!
If you currently trade stock options –
Do you use volatility-based trades as part of your trading strategy? If so, please share an example when high volatility allowed you a ‘quick profit’.
If you do not trade during high volatility markets –
What is it that you are most afraid of that prevents you from venturing into such markets?
