Volatility plays a significant role in the pricing of options. As traders, we must understand and pay close attention to a market’s volatility as we build our option strategies. When we see extreme volatility in a market, we feel an overwhelming sense of uncertainty. The normal psyche of a trader is to react emotionally as markets make sharp moves higher and lower. This emotion and shift of sentiment has a direct relationship to the pricing of options. Traders will bid up the premium on both the call side and put side of that given market.
On the flip side, we become comfortable with a market when volatility is very stable. Consistency with the market and your approach to the market creates comfort. When we see a market repeatedly bounce off of a support level or pull back from a resistance level, we feel more confident with these levels. These levels allow traders to have a gauge on a market’s trading range. Options that are outside of this range can be viewed as having a lower probability of finishing in-the-money and therefore will be assigned a smaller premium.
To further clarify this concept, let’s consider the corn market. From the period of June 15th to the end of July, we traded in an extremely wide range. The market rallied from $5.80 per bushel to $8.30 per bushel. This is a 43% increase in the value of the contract in a little over a month. With such a drastic move higher, you might expect a continuation of this trend, or you might expect a drastic correction in the market. Either way, this is a very wide range so there is a possibility that the market could make a big move in either direction. That being said, the trade is going to assign high premium to options that are far from the current trading price, both to the upside and downside. During this time period, the market price was around $8.00. An option with a little over 85 days left until expiration and is one full dollar above the current price ($9.00) is valued around 25 cents. A $7.00 put is valued around 21 cents. Both options are one full dollar away from the current market price.
Now we compare that to the price of options one full dollar out of the money with equal time from May to June. From May to June, we saw the price of corn trade in a much tighter range. We traded between $5.50 and $6.50 during this time period. From high to low that is an 18% change in contract value. On June 1st, we were trading around $5.50. If we price out options $1.00 higher and $1.00 lower, we will find a drastic difference in their option premium. A $4.50 put on June 1st was trading around 6 cents. A $6.50 call on June 1st was trading around 5 cents. As you can see, volatility has had a major impact on the value of out-the-money options.
How do we evaluate our option strategy based on a market’s volatility? As you can see from our example, options are very expensive in volatile environments. Theoretically speaking, we want to sell options when volatility is high and buy options when volatility is low. When we see markets, like corn, trade in such a volatile manner, we would want to find a way to collect some premium. If we wanted to participate in the market by purchasing an option, it would be advantageous to buy a call or put spread.
By using a spread, we are trying to help neutralize the additional volatility premium added to options. We are simultaneously buying an option closer to the current market price and selling an option further away from the current market price. If we were to just buy an outright call or an outright put, we would only be paying for the additional volatility premium and not benefitting from collecting any of it. We would need the market to move much further in our favor to reach our breakeven point towards expiration. Should volatility slow down and the market consolidate, we would lose premium on our outright options even if the market stays at the same price. We will lose both the time premium and the volatility premium. A spread will neutralize this to some degree because the option we sold would also be losing some of its time premium and volatility premium, thus holding a higher net value.
The exact opposite is true when volatility is low in a market. We would want to buy outright options when volatility is low because we understand a spike in volatility will help improve our option’s premium. We will still need to forecast the market’s direction accurately and compensate for time decay, but premiums should be much lower when we enter. In our example above, a call option $1.00 out-the- money would cost us around 25 cents in a volatile environment. At expiration, we would need the market to move $1.25 in our favor to breakeven. In the second example when volatility was low, we only had to pay 6 cents for an option $1.00 out-the-money. At expiration, we would need the market to move $1.06 in our favor to breakeven. This is a difference of 19 cents in volatility alone.
This is just one simple example of how you can interpret volatility for your option trading. You might be surprised how paying attention to this basic concept could improve your trading. There are several other factors we must consider when building an option strategy, but volatility should play a vital role when determining how you want to position yourself in the market.
Stay tuned for future articles on this subject as we dig deeper into historical and implied volatility.
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