Volatility with Options

Volatility Is the Stock in Trade with Options

If not for the phenomenon of volatility, there would be no purpose for options, as without volatility prices would simply not change at all. Buying options would be pointless, although if someone wanted to buy an option for an asset without any volatility, someone would sell you one, as the risk to them would be zero and they would simply collect whatever premium is paid by the buyer.

The price of assets do move though, to one degree or another, and the amount that they may be expected to move during a given time period is called its volatility. The more volatile something is, the more potential for gain there is for options buyers, although this also tends to increase the potential for the option to finish out of the money and thus expire worthless if held to expiration, or be sold at a loss if the option buyer liquidates the options prior to expiration.

Options sellers, also known as options writers, take on more risk when volatility increases, as they are responsible to pay out the value of the option.

The more volatile an option is, the more it may move against them, and the greater the potential losses are for them. While volatility may mean an increased likelihood of their collecting the premium and thus winning the trade if the option finishes out of the money or the position is closed out prior to that at a profit, it is this increased downside risk that drives a lot of the pricing of volatility into options premiums.

Options buyers tend to love volatility though, much like lottery players prefer larger jackpots, as this increases the potential upside for them. We need a certain amount of volatility to make buying an option for speculative purposes make sense, as if the odds of making enough money to make buying the option make sense is too low, there would not be a reason to speculate on them at least.

Those who use options for hedging take the opposite view, as they are using options to protect them against volatility. If you have a position with a certain stock and you want to protect yourself against taking too big of a loss over a certain amount of time, you may purchase an option which will offset your losses to some degree should it become too volatile against you.

Volatility therefore does play a fundamental role in options pricing and trading options in general, and while there are other factors that are used in order to seek out a fair market price for an option, nothing is more important than the asset’s tendency to move by a certain amount.

Volatility Does Tend to Be Priced In Though

The pricing of options is a very sophisticated endeavor, where complex calculations are arrived at using computers to decide how much or how little premium should be charged or paid in a given instance with a given option.

Those who are not too familiar with options tend to think that this process is simpler than it is and think that they can somehow outwit the formulas using what amounts to a very simplistic approach to deciding whether there is an advantage with a certain options play.

Volatility with OptionsOptions traders abound, and it’s not that one cannot come up with good trading strategies with trading options, but traders will have to rely on their trading skill and not on what they think is some sort of innate ability to make statistical evaluations.

While the price of options are indeed driven by supply and demand, as is everything else, how volatile an asset is, or any other characteristic, is going to be already priced into the option. Much of this is based upon best guesses though, and the guesses aren’t always right, but they are correct to a great degree based upon what we know already.

It is the unknown that is the factor that has the potential to move prices to where one can obtain a trading advantage, but nonetheless, there are many who look at options pricing in terms of seeking bargains, seeking inefficiencies in other words, and one of the things that are looked at is the degree of volatility that an asset may have.

Higher degrees of volatility are already accounted for though. If an asset tends to be more volatile for instance, then the premium paid is going to be higher, and vice versa. If a trader is looking to buy an option that is more volatile, it essentially will have to move more for a profit to be realized than with a less volatile option.

Option Volatility is Forward Looking and Comprehensive

While the historical volatility of an asset is certainly accounted for in determining the volatility of an option, it is the potential volatility going forward that really matters, and not so much what the average volatility of an asset has been in the past.

The forward looking measure of volatility that options pricing uses is called implied volatility, as opposed to average volatility of the past, historical volatility.

Circumstances do change, as well as present themselves differently, depending on the market environment in the present and in the near future, during the lifetime of the options contract. Perhaps the situation may dictate that an asset may be expected to be more volatile in the near term than has been in the past, and it only makes sense to use current views on its volatility.

Market conditions overall will also influence implied volatility, especially during bear markets, which tend to be more volatile than bull markets. For the purposes of options, we’re only looking at how much something may move over a rather brief period, and things simply tend to go down faster than they go up, even though moves to the upside tend to be more sustained.

So if you think that something may move more than it tends to and think that you have an advantage here, it pays to think twice, because this and many other things already tend to be well accounted for with options pricing.

One certainly will tend to do better trading options during times of higher volatility, just like one tends to do better trading the assets itself, but given that the assets themselves are neutral to implied volatility at a given price and point in time, trading options during these times actually build in a disadvantage toward taking full advantage of this.

If an asset is plunging, and you sell it, and it continues downward, you can capture the full move this way. Buying a put on it though will have the premium of the put increased to reflect this greater risk, and while this is still a tradable situation in some cases, the added premium will tend to reduce profits.

This only makes sense though as the sellers of these options are taking on more risk as volatility increases, and they need to be compensated for this, or it would not make sense for them to sell the options.

Options sellers in particular tend to have a good understanding of options pricing and what they should be charging, and while mistakes are made of course, you can count on the obvious, the things that appear to the eyes of many options buyers, are seen as well by options sellers.

The idea here is to get to a situation with options pricing to get as close to an efficient market as possible, where there is no advantage to either party in the trade. While we don’t achieve perfect efficiency overall, we at least seek it in the present, and end up coming pretty close to it, in the present.

Speculating on Volatility with Options

When traders take a position in something, they are anticipating a certain movement in the price of the security over a certain period of time, and expect that the probabilities of that are more likely than not, such that they may achieve a profit overall by making these trades.

Options speculation is a little different, as we instead need to shoot for a price movement in excess of how much the options market thinks will happen, and also need to do so in a probabilistic manner that yields a profit over time.

What makes options selling so enticing to many is the prospect of capturing a lot of what we could call dead money on the other side of their trades, and there is certainly plenty of that. Hedgers aren’t looking for a profit so we could say that this money is pretty dead, although many options traders add to this heap by making poor trading decisions.

Whenever we speculate on options, we must always consider what advantage buying options versus buying the underlying asset or the underlying security would be. At a minimum, we need a good reason to go with the options instead, a clear advantage, which often simply is not present with options.

The fact that you can make more money potentially with stock options versus actually trading the stock is something that appeals to many traders, and this is almost purely due to the added leverage that options offers, but leverage can be had other ways, such as with futures or with contracts for difference, where factors like implied volatility are not compensated for.

When we trade actual securities and not options on them, there is no premium paid for implied volatility, which in concert with other factors such as time decay primarily drives option premium pricing.

This is not to say that a trader cannot be successful speculating on options, but the bar is certainly set higher with options than with other trades, and we may expect quite reasonably that this higher bar is going to be both harder to reach and will also produce lesser returns dollar for dollar.

Options traders may argue that the fact that options trades require less dollars and therefore would be more efficient potentially in taking advantage of volatility, but while this may have some truth when compared to trading stocks with much smaller amounts of leverage, high leverage can be had in other ways besides with options trading, so this is not really a convincing point.

When we factor out the leverage advantages, options trading then becomes reduced to paying a volatility premium rather than not having to pay one with other forms of trading. The risks are greater to those on the other side of options trades and they need to be compensated for it.

The lure of higher volatility relative to their investment is what gets traders so excited about options, but in order to fully appreciate whether this is an actual advantage or not, we really need to compare this form of trading to other highly leveraged forms of trading that we may partake in instead, the true opportunity cost of the trade.

From this perspective, we can see that the premium paid for the opportunity for the higher volatility that options trading provides is the cost of the leverage, and we need to be aware that we may be able to get the leverage we desire much more cheaply, by borrowing it or by just making a deposit on a futures contract.

We may or may not be able to get the amount of leverage we desire on a particular asset, such as a particular stock, but as traders, we still need to be comparing opportunities across assets and asset classes in order to decide what best to trade and how, which are still opportunity costs.

When we do consider opportunity costs properly, we will tend to see that we are giving up quite a bit in trying to take advantage of volatility in trading options, because of the premium paid for this that is at least to a significant degree built into the price of options.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: eric@marketreview.com

Areas of interest: News & updates from the Commodity Futures Trading Commission, Banking, Futures, Derivatives & more.