How To Trade Options Using Stock Market Volatility
Options are a form of leverage. Each option is a contract that gives the owner the right to buy or sell a fixed number of stocks at a certain price by a certain date. They allow increased returns at the cost of increased losses.
With options, it's possible to multiply potential profits with just a fraction of the capital needed without using leverage. The reverse is also true. Losses will be multiplied if the trade happens to go the wrong way.
It is therefore wise to handle options with care. Managing risk with regards to options becomes extremely important due to the potential of significant losses. Anyone using options should know as much as possible about options.
How are options used in the stock market
With options, an investor or trader has to make a decision in what direction the price of the underlying security will move and when. The most common method of using options by retail investors is to buy call options when the price rises or to buy put options when the price falls.
If the price of the underlying security rises, then the price of the call options will also rise. Assuming all else being equal. In this case, the owner of the call option is long. But if the price of the underlying security falls, then the price of the put option will rise. The owner of the put option is said to be short.
Another way is to sell call options if you think that the price will fall or to sell put options if you think the price will rise. In any case, if the price moves in the direction that you predicted, the options that you owe should rise in value. However, that is not always the case and the reason is often due to volatility.
How does volatility affect options pricing
The price of all options is determined using a mathematical formula known as the Black-Scholes or Black-Scholes-Merton formula, named after the inventors of the formula. One of the factors used in the formula is volatility and more often than not ignored by many people.
Volatility can rise or fall due to several factors. Some options are naturally more or less volatile. General stock market uncertainty can affect the volatility of a specific option. Increased volume in trading of certain options can also increase volatility.
In general, increased volatility will increase option prices and reduced volatility will decrease option prices. This applies to both call and put options. It is therefore important that you do not ignore the role of volatility in options, but incorporate them if you're trading options in the stock market.
How volatility can lead to losses
Many people tend to focus exclusively on the price of the underlying security. For example, some people assume that since the price of the underlying rose, the call option should also increase in value. However, the underlying price is not the sole factor that determines the price of the option.
If you happen to buy a call option when volatility is high, then it's possible that the call option will be reduced in value when volatility drops, even though the price of the underlying security may have risen in price as you predicted.
People are then surprised to find out that they've suffered a loss even though the price moved in the direction they predicted. This happens because they did not pay enough attention to the role of volatility.
One example of where this often happens is during earnings. When a company is about to announce their earnings for the quarter, volatility can often spike. Once earnings have been announced, the volatility will usually drop significantly.
Many people tend to buy options before earnings expecting a huge move in price. But this is usually not a good idea. The prices for these options before earnings are often inflated due to volatility. Once the volatility is gone, prices will go back to where they normally are.
All of this results in a loss for the option buyer. Had the buyer taken volatility into account before deciding to buy the options, he or she could have avoided incurring needless losses. Volatility is not something to be ignored.
Alternative uses of volatility
Volatility itself is also traded. Some people do this by buying call options related to the VIX when they think that volatility is going to rise. If they think that volatility is about to fall, then they buy put options related to volatility.
Another alternative is to anticipate the rise in volatility and try to profit from that. One way to do this, is to buy both call and put options and close them shortly before earnings when volatility is at its highest.
Other options strategies can also be used using the basic premise that volatility is about to rise. The increase in volatility and thus pricing could offset the time decay or theta associated with options and result in a gain for the buyer.
How to avoid losses with options due to volatility
Besides the price direction of the underlying security, volatility is another factor to take into account to determine what you should do when you're trading. It is important to know that volatility does not stay high for very long. It can stay there for a while, but will usually come down after some time. You can use this knowledge to your advantage.
In general, you should buy options, whether it's call or put options, when volatility is low and therefore cheap and sell options when volatility is high and therefore expensive. If you want to be long because the price will rise, then you can buy call options provided volatility is low.
If volatility is too high, then it's better to be long by selling put options. Conversely, if you want to be short because the price will fall, then you can buy put options as long as volatility is low. If it's high, then you can be short by selling call options.
People are normally allowed to buy call and put options. However, some brokers have additional requirements before you're allowed to sell options. It's a good idea to have this ability. With the combination of buying and selling call and put options, you can implement many options strategies that are otherwise nor possible with simply buying call and put options.
Whatever you do, always remember to avoid buying options when volatility is really elevated. Sticking to this principle should help reduce potential losses and preserve your capital. As long as you haven't lost your capital, you are in a position to profit from the stock market.
Price of underlying security will fall
Price of underlying security will rise
Volatility is low
Buy put options
Buy call options
Volatility is high
Sell call options
Sell put options