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Option Volatility Trading

Updated on June 1, 2010

Option Volatility Trading

So what exactly is option volatility trading? I’m going to go out on a limb and assume that you’re not a complete options novice, because you probably wouldn’t have even known to look for information on option volatility trading if you didn’t have at least a basic level of understanding where options fundamentals are concerned. So I’m going to skip past all of the explanations of what call options are, and what put options are, and strike prices, and so forth, and get down to the issue at hand. There is a major secret to options trading that not many people (even active options traders) are consciously aware of, and it is the fact that any options trade you make is really a volatility trade. Trading options, when it boils down to it, IS trading volatility. Now I know that there may be some people who would want to debate me on this point, saying that they only use options to insure their portfolio in case their underlying stock plummets in price (or rises in price, if they’re short). That’s not the type of investment style I’m talking about. When I say “trading options”, I mean trading the pure option, whether or not you own the underlying stock. I mean buying an option with the sole purpose of later offsetting it at a profit (or, for the option writers, selling the option for the purpose of either letting it expire or offsetting it later once the premium decays). So what do I mean by “trading volatility” then? Well, before I get into that, it would be good (if for nothing more than the sake of review) for me to explain what volatility is. Volatility is basically the measurement of the instability of an option’s premium. How unstable is the option’s price? Does the premium fluctuate up and down in violent swings? If so, you have a high volatility option. If the premium remains relatively stable, you have a low volatility option. Volatility is what gives us all of our profit opportunities, so it’s important to understand its function when evaluating potential trades.

Image courtesy of Microsoft Office Clip Art
Image courtesy of Microsoft Office Clip Art

Trading Option Volatility

If you purchase an option that’s way out-of-the-money when compared to the actual market price, you’re more than likely trading a high-volatility option. The reason for this is that there is more uncertainty to the option’s premium the farther out the strike prices go. If you bought an option that had a strike price that was at or very near the actual trading price (for example, if you bought an option with a $35.00 strike price and the stock was trading at $34.50), the option’s premium will remain relatively stable because it’s so near to the actual prevailing market price. But, if the stock’s price is at $34.50, and it’s in the middle of a strong upward move in price, your call option with a $45.00 strike may actually have a chance of producing a profit, due to the high probability of the market continuing to move in that direction. Volatility will many times dictate how uneasy the option writers are in the pits. An option writer always wants volatility to decrease, because then he knows that time is on his side, and the premium of the option will more than likely just waste away until it’s gone with no fanfare. But if an unskilled option writer decides to sell options just as they are entering into a seasonal volatility increase (such as happens with the Grains in commodities in the summer months), he will more than likely have to eat most of his trades, because he didn’t take volatility into account. A simple formula for understanding option volatility trading is if you think that volatility will increase, then buy options, but if you think volatility will decrease, then sell (or write) options. Looking back on what I’ve written so far, I feel like my thoughts were a little scattered with this hub, but it’s all good; I believe there are some “nuggets” here that any beginning or intermediate option trader can glean from.

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      Moda 

      3 years ago

      Thanks for sharing. Your post is a useful cortoibutinn.

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