PROFIT WITH OPTIONS CHAPTER 6

6 TRADING VOLATILITY LE A R N I N G OB J E C T I V E S The material in this chapter helps you to: • Recognize volatility abnormalities and use them in prof-itable trading strategies. • Understand and use the measures of option price change (“greeks”). • Read and interpret price distributions. • Decide on the appropriate strategy when volatility is skewed either in the positive or the negative direction. • Know when to use ratio spreads and backspreads. Volatility trading should appeal to more sophisticated deriva-tives traders because, in theory, trading volatility does not in-volve predicting the price or direction of movement of the underlying instrument. Instead, it means, essentially, to first look at the pricing structure of the options—at the implied volatility—and then, if abnormalities are identified, to attempt to establish strategies that could profit if the options return to 179 180 TRADING VOLATILITY a more normal value. Simply put, a volatility trader tries to either (1) find cheap options and buy them or (2) find expensive options and sell them. Typically, a volatility trader establishes positions that are somewhat neutral initially, so that profitabil-ity emphasis is on the option price structure rather than on the movement of the underlying stock. This chapter shows you how to use volatility to your advantage. NEUTRALITY This neutrality is usually identified by using the deltas of the options involved to create a delta neutral position. In practice, any neutrality most likely disappears quickly, and you are forced to make some decisions about your positions based on the movement of the underlying instrument anyway, but at least it starts out as neutral. That may be true, but you must under-stand one thing: It is certain that you will have to predict some-thing in order to profit, for only market makers and arbitrageurs can construct totally risk-free positions that exceed the risk-free rate of return, after commissions. Moreover, even if a position is neutral initially, it is likely that the passage of time or a signif-icant change in the price of the underlying will introduce some price risk into the position. The price of an option is determined by the stock price, strik-ing price, time to expiration, risk-free interest rate (0% for fu-tures options), volatility, and dividends (stock and index options). Volatility is the only unknown factor. The “greeks,” delta, theta, vega, rho, and gamma, are all measures of how much an option’s price changes when the various factors change. For example, delta is how much the option’s price changes when the stock price changes. This is a term that is known to many option traders. Delta ranges between 0.00 (for a deeply out-of-the-money option) to 1.00 (for a deeply in-the-money option). An at-the-money option typically has a delta of slightly more than 0.50. NEUTRALITY 181 The theta of an option describes the time decay—that is, how much the option price changes when one day’s time passes. Theta is usually described as a negative number to show that it has a negative, or inverse, effect on the option price. A theta of −0.05 would indicate that an option is losing a nickel of value every day that passes. Vega is not a greek letter, although it sounds like it should be. It describes how much the option price changes when volatil-ity moves up or down by 1 percentage point. That is, if implied volatility is currently 32% and vega is 0.25, then an option’s price would increase by 1⁄4 point if implied volatility moved up to 33%. When interest rates change, that also affects the price of an option, although it is usually a very small effect. Rho is the amount of change that an increase in the risk-free interest rate would have on the option. Finally, gamma is the delta of the delta. That is, how much the delta of the option changes when the stock changes in price by a point. For example, suppose we knew these statistics: Stock Price 50 51 Option Price Delta 5 0.50 51⁄2 0.53 When the stock moved up from 50 to 51, the option’s price in-creases by the amount of the delta, which was one-half. In addi-tion, since the stock is a little higher, the delta itself will now have increased, from 0.50 to 0.53. Thus the gamma is 0.03—the amount by which the delta increased. We will talk more about gamma and its usages later. So, not only are the factors that determine an option’s price important, but so are the changes in those factors. For those familiar with mathematics, these changes are really the par-tial derivatives of the option model with respect to each of the 182 TRADING VOLATILITY determining factors. For example, delta is the first partial de-rivative of the option model with respect to stock price. VOLATILITY AS STRATEGIC INDICATOR Volatility trading has gained acceptance among more sophisti-cated traders—or at least those who are willing to take a mathe-matical approach to option trading. This is because volatility is really what earmarks the only variable having to do with the price of an option. All the other factors regarding option price are fixed. As listed previously, the factors that make up the price of an option are stock price, striking price, time to expiration, risk-free interest rate, dividends (for stock and index options), and volatility. At any point in time, we know for a certainty what five of these six items are; the one thing we don’t know is implied volatility. Hence the only thing that a “theoretical” option trader can trade is (implied) volatility. Unfortunately, there is no way to directly trade volatility—so one can only attempt to buy cheap op-tions and sell expensive ones and then worry about how the other factors influence the profitability of his position. Imagine, if you will, that you have found a stock that rou-tinely traded in a fixed range. It would then be a fairly simple matter to buy it when it was near the low end of that range, and to then sell it when it was at the top of the range. In fact, you might even decide to sell it short near the top of the range, fig-uring you could cover it when it got back to the bottom of the range. Occasionally, you are able to find stocks like this, al-though they are rather few and far between. However, in many, many instances, volatility exhibits this exact type of behavior. If you look at the history of volatility in many issues, you will find that it trades in a range. This is true for futures contracts, indices, and stocks. Even something as seemingly volatile as Microsoft, whose stock rose from about 12 to 106 during the 1990s, fits this pattern: its implied volatility Team-Fly® VOLATILITY AS STRATEGIC INDICATOR 183 never deviated outside of a range between 26% and 50%, and most of the time was in a much tighter range: 30% to 45%. Of course, there are times when the volatility of anything can break out to previously unheard-of levels. The stock market in 1987 was a classic example. Also, volatility can go into a slum-ber as well, trading below historical norms. Gold in 1994 to 1995 was an example of this, as historical volatility fell to the 6% level, when it normally traded about 12%. Despite these occasional anomalies, volatility seems to have more predictability than prices do. Mathematical and statistical measures bear this out as well—the deviation of volatilities is much smaller than the deviation of prices, in general. You should recall that there are two types of volatility—im-plied and historical. The historical volatility can be looked at over any set of past data that you desire, with 10-day, 20-day, 50-day, and 100-day being very common measures. Implied volatility, on the other hand, is the volatility that the options are displaying. Implied volatility is an attempt by traders and market makers to assess the future volatility of the underlying instrument. Thus, implied volatility and historical volatility may differ at times. Which one should you use if you are going to trade volatility? There is some debate about this. One certain thing is that historical and implied volatility converge at the end of an option’s life. However, prior to that time, there is no assurance that they will actually converge. An overpriced option might stay that way for a long time—especially if there is some reason to suspect that corporate news regarding new products, takeovers, or earnings might be in the offing. Cheap options might be more trustworthy in that there is very little insider information that can foretell that a stock will be stagnant for any lengthy period of time. So, it is often the case that the better measure is to compare implied volatility to past measure of implied volatility. That may point out some serious discrepancies that can be traded by the volatility trader. In this case, we would say that the prediction of volatility might be wrong. That is, implied volatility—which is a ... - tailieumienphi.vn