Volatility in options trading: strategies and insights
A volatile asset or market means a significant price swing is likely to follow – but it’s often difficult to predict whether the asset will soar or plummet. This article explains volatility in options trading, trading strategies and techniques based on volatility, and how you can learn to try and benefit from it.
Volatility refers to the often significant and sudden variations in the price of an asset. A sharp rise or fall can be down to many factors, which can either be expected – such as a company’s anticipated earnings report – or take the market by surprise.
For example, a shocking news story about a company or its leaders has the potential to shake up markets. There are two distinct types of volatility that should be considered:
- Realised volatility (RV): This measures how fast the price of the underlying asset has changed over time. Put simply, it’s a percentage calculated by working out its average price over a period of time, and how far and often it has deviated from that average. Realised volatility is sometimes also known as statistical or historical volatility.
- Implied volatility (IV): This is the market’s forecast of how far the price of an underlying asset will fluctuate in the future. It considers factors including the price of the underlying asset, the strike price of the option and the duration of the option contract. As the term ‘implied volatility’ suggests, it’s a measure of the volatility one might expect due to these factors. An option with higher implied volatility tends to cost more because of its potential to deliver significant returns, though it also raises the possibility of an option being out-of-the-money at its expiration.
Strategies for options trading in volatile markets
There are a number of established option volatility trading strategies. If implied volatility is high and traders expect it to decrease, they may enter short option positions. When implied volatility falls, the writer will benefit from the falling option premiums, allowing them to purchase back the contracts they sold – at a lower price.
When volatility spikes, the value of options can soar significantly, benefiting buyers of options. They can sell long contracts at a profit, since the option premiums would have risen. In this instance, an option seller/writer would suffer from having to buy back options at a higher premium.
Popular option volatility strategies and techniques include the ‘straddle’ and the ‘strangle’.
Long straddle
A straddle, as its name suggests, is a neutral options strategy that involves the trade of both a put and a call option on the same underlying asset, each with the same strike price and time until expiration.
This is potentially an attractive strategy for traders purchasing options in a volatile market, because it has limited risk, with unlimited profit if the asset’s price moves dramatically, regardless of the direction.
There is a trade-off between choosing cheaper contracts that expire sooner, and buying longer-dated contracts, which are more expensive but allow more time for the market to move.
Example
Company X is trading at £50 a share. Chris thinks the price will move significantly but isn’t sure which way. At-the-money call and put options (with a £50 strike price) are trading at £2, with each contract containing 100 share options.
Chris buys one call (£2 x 100) and one put (£2 x 100), both with identical expiration dates. He has paid a total £400.
The stock leaps to £60 a share at expiration, giving him a £10 gain per share in his call option. He exercises the call option, lets the put option expire and returns a total of £1,000. Minus the £400 premium, he has made a profit of £600.
But he also profits even if Company X’s shares fall to £40 a share. In this case, the call option will expire worthless, but the put option will be in-the-money by £10 per share – again, a return of £1,000 and, minus the £400 premium, making a profit of £600.
As long as the stock significantly moves one way or the other, Chris can make unlimited profit on either the call or the put, but only lose his premium on the other. The only way for him to lose would be if there was little or no volatility. If, when the contract expires, the shares are still trading at £50, both the call and put options would expire worthless, netting a loss equal to the £400 premium.
Strangle
A strangle differs from a straddle in two ways:
- The trader simultaneously buys call and put options with the same expiry date but at different, out-of-the-money strike prices
- The call strike price is higher than the price of the underlying asset, and the put strike price is lower
The cost, and therefore the maximum risk is lower in comparison to a straddle, meaning you can make more trades for your money. The downside is that the two strike prices are further from the at-the-money price, which means there must be a larger move in the underlying asset before you begin to break even.
Example
Company Z is trading at £50 a share. You buy a call option with a strike price of £55, with a premium of £3 per share, making a total of £300. You then buy a put option with a strike price of £45 and the premium is £2.90 per share – a total of £290. You therefore paid a total cost of £590.
The stock soars to £65 a share. You exercise the call option, which realises £10 per share, and you gain £1,000. You then let the put option expire. Your payoff of £1,000 minus the two premiums (£300 and £290) gives you a net profit of £410.
However, the stock had to move significantly for you to benefit. If it had risen to £60 a share, you would have made £5 per share on the call option, with a payoff of £500, which wouldn’t have covered the cost of the premiums (£590).
In another scenario, the stock plunges to £35 a share. The call option expires but the put option, with its strike price of £45, has gained £10 a share, making a total £1,000, which, minus the premiums, gives you a profit of £410.
In both cases, the potential for profit is unlimited. However, the price had to climb significantly above the call strike price or fall significantly below the put strike price to make any profit. If the underlying price trades between the two strike prices at expiration, then your maximum loss would equal the sum of the premiums is made.
Risk-management techniques
As with any form of trading, the more volatile the market, the greater the risk, so it’s important to understand how to manage this when trading volatility with options.
If you own an asset, you can set a stop-loss order that takes effect when the price falls below a certain point (or, if you’re shorting stock, rises past a particular value). This figure is the amount you would be prepared to lose, and it makes sense when buying options to pay no more than that figure on premiums. However, stock stop losses are not foolproof. For example, they don’t cover gap openings, when the market opens at a different value from its previous close without any trading taking place.
When buying options, it’s impossible to lose more than the premium you pay, and by using straddle or strangle strategies with simultaneous call and put positions, you can potentially capitalise on various scenarios, even when a market is trading sideways. Sellers can, as previously mentioned, make a large profit on premiums when volatility is high, but they also face the risk of potentially unlimited losses from adverse movements in the underlying asset.
Tools and resources for analysing volatility
How do you know when the market, or an asset, is volatile? Essentially, you need to understand the forces driving the market, as well as the standard deviation: how much, on average, its value fluctuates away from the mean.
The very definition of volatility means it’s challenging to forecast accurately, but there are various indicators and calculations to help you determine the probability of fluctuation, as well as when and how volatile it’s likely to be. These include:
The average true range indicator (ATR)
The ATR calculates the true range of volatility of a given trading period (day, hour, minute, week) by taking the highest value of these three equations:
- Current high minus previous close
- For day trading this will be today's high to yesterday's close - Current low minus previous close
- For day trading this will be today's low to yesterday's close - Current high minus the current low
- Today's high to today's low
This calculation is made several times over a chosen time to give you an average, which you can use as a baseline to calculate volatility. A higher ATR indicates greater price movement and volatility, which might lead to higher options premiums.
Conversely, a lower ATR suggests less price volatility, potentially leading to lower options premiums. Traders might use the ATR to gauge the potential risk and reward of a particular options trade or to set stop-loss and take-profit levels.
Volatility Index (VIX)
This is a real-time index derived as a percentage using the pricing of S&P 500 index options. It’s a complex mathematical formula, but its headline figures give a snapshot of future expected volatility over the coming 30 days. It’s a tool used by investors to measure the level of fear or risk in the markets.
Bollinger Bands
This indicator consists of three lines on a graph indicating an asset’s upper value, lower value and moving average over a certain period, and is designed to show when assets are overbought or oversold. When the lines – or bands – narrow and “squeeze” together, it’s a general indication that volatility is likely. When they move further apart, it indicates the market or asset price is stable.
There are several other indicators of volatility. It should be noted that no single tool is a reliable barometer of volatility, and trading decisions should be made by correlating with other tools and indicators.
Summary
Understanding the metrics of realised and implied volatility, and options-focused tools and indicators, is key to trading options on volatility. These metrics can help predict the asset's future price movements and volatility.
There are risks, particularly if you sell rather than buy options, with sold calls you can potentially face unlimited losses if the market moves against your position sharply. For sold puts, loses can significant if the price drops substantially. So it's important to manage your risk whenever you're trading options.
FAQs
Is volatility options trading risky?
How can I start to trade volatility options?
How does implied volatility affect options pricing?
Can I make a profit if asset prices suddenly go down?
How do I minimise the risk of volatility options trading?
Do I have to place call and put options at the same strike price?
No. You can place call and put options at the same strike price through a strategy called a straddle, but you can potentially profit by buying a call and put at different strike prices, which is known as a strangle.
Straddles and strangles are just two methods of trading based on volatility expectations. There are many other ways traders can trade on volatility, or limit their risk to volatility, through options.
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