How to Use Options in a Volatile Market Climate

This article originally appeared in FutureSource’s Fast Break Newsletter on December 16, 2005.

Today’s volatile markets offer many opportunities. Along with these opportunities come risks. The greater the volatility in a market, the bigger the risk. Many savvy investors are drawn to the options markets as a way to take advantage of large price swings while limiting their risk to a defined dollar amount. This, on first reading, sounds like a smart idea. Take a market position with unlimited profit potential while limiting your risk to fixed dollar amount.  What is not to like?

If you had an opportunity to risk only $1 on a trade, but there was no chance of it paying off, you are better off keeping your dollar. A trader that buys an option that is cheap in dollar terms is likely unaware of how expensive that option is in terms of the chance the option will expire in the money. Options are often a great way to play a volatile market; it just has to be done right. If a carpenter only used a hammer, even if he were the most skilled carpenter in the world, he could not build a house. A carpenter needs to be skilled in using a hammer, but he must also be able to use a saw, square, level, drill, etc. Traders that only make outright purchases of long calls and puts are like our single talent carpenter. They will be unable to “build” the trading account they desire.

If we look at the trading practices of professional option traders, or locals, we can find some help. Options locals are market makers; they bid and offer in a certain futures option market (buy from the sellers and sell to the buyers). They are constantly aware of how their position is sensitive to changes in price, time and implied volatility. They adjust their position according to their market bias. Public traders, although they are not market makers, can help themselves by learning how changes in price, implied volatility, and time affect the value of different options and spreads.

This article assumes the reader has a basic knowledge of calls and puts and is familiar with basic spreads.

Implied & Historic Volatility

Today we will discuss two types of volatility; implied and historic. Implied volatility is calculated from an option pricing model, usually the Black-Scholes Model. Black-Scholes is an equation with five variables: strike price, underlying price, time until expiration, interest rate and implied volatility. The four known variables are used to solve for the unknown, which is implied volatility. Implied volatility is a way of telling the relative value of an option. Without the benefit of implied volatility, it is difficult to determine which option is more expensive – a $2.00 corn call with 30 days to expiration that is trading for 6 cents or a $2.20 call that has 90 days until expiration and is trading for 6 cents. Historic volatility is simply the actual price variance for a specific underlying commodity over a specific time period. Historic volatility is usually calculated over a 20 day trading period, which is roughly how many trading days are in a month. Implied volatility and time until expiration are calculated using calendar days.

How do we better use these “tools” to make trading decisions?

First, we need to learn how changes in the underlying markets affect different strategies. If we are simply long calls, the passage of a week with the underlying remaining at the same price level would lead to a lower value for the calls, right? Not necessarily. If implied volatility increased enough, it would easily offset the loss in value due to the passage of one week in time.

If a trader is long a call and in two weeks the underlying market has moved up 5%, how much will the option gain in value? What has happened to implied volatility in that time period? What type of price volatility was the implied volatility pricing into the call price? In 2003, soybeans traded above $10.00 for only the third time in history and implied volatility was at historic levels. The implied volatility at-the-money implied that the market was expecting a range of 42 cents every day. If the market is pricing in the expectation of large price movement, a normally good move in the underlying will have little effect on price.

As you can see, with options it is not easy to determine what will happen to our position value by looking at only one variable in the equation that determines option value. It takes a little more work and study to learn how options work in different situations, but the rewards can be well worth it. We will cover a matrix of positions and illustrate how they are affected by different variables. Learning how changes in time, price, and volatility effect option prices will help traders chose the strategy that best matches their market ideas for any given market condition.

Implied volatility

Many traders are attracted to a market that has just made a large price move or “broken out”. In a typical breakout to the upside, implied volatility explodes as speculator demand for calls is combined with the uncertainty and risk the option locals face. This “bids up” the price of all options. Many times a breakout retraces and the call buyers are shocked at how quickly their calls have lost value.  This common result is due to implied volatility. Traders bid up implied volatility buying calls. The high priced calls, in terms of implied volatility, lose a great deal of value as the market trades lower. Speculators who chased calls higher on the way up then typically sell their calls, further pressuring implied volatility as the underlying price drops. This combination of lower implied volatility, lower underlying price and the passage of time usually causes a large drop in the value of calls. The novice option trader is usually amazed at the devastation this scenario does to their account balance.

In periods of high volatility, local traders will want to be “short vol” or short implied volatility. They normally will try and accomplish this while managing their exposure to price moves in the underlying. Local traders are normally “delta neutral” – price movement neutral traders who adjust their positions constantly in order to take advantage of changes in volatility and time.

Directional Trading

An off floor trader is more likely to be interested in trading a price direction.  It is possible that the outright purchase of a call or put may be the best choice.  Many times, however, an outright purchase of a call or put is not the best strategy. In a high implied volatility situation a trader’s volatility exposure is just as important as their directional bias. As discussed above, a price breakout that attracts a buyer to the underlying market usually has also increased the implied volatility.

How can we adjust for a high implied volatility market?

Simple vertical spreads are generally the best choice for a directional move in a high implied volatility market. A call spread will become cheaper as implied volatility increases. Call spreads in a low volatility environment are not the best choice as the benefit of a sharp move higher would be offset by an accompanying increase in implied volatility.

A great exercise for option traders is to look at the common trades they use: long call, long put, long call spread, long put spread, and determine how the passage of time and changes in volatility will effect the value of the position.

The following table shows how changes in time and volatility affect the four strategies listed above using at-the-money examples:

As we can see from this simple table, a trader can make money buying a call spread in a high volatility environment without the underlying market moving higher, simply through the passage of time and a decline in volatility.

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