For most asset classes, trading volatility is relatively straightforward. All it takes is to observe the asset’s price change over time and determine a suitable buy point and sell point. However, for options trading, volatility isn’t that simple. This is because options traders do not directly buy the security; instead, they purchase a derivative contract that offers them the right to trade the security at a preset price on or before a specific date. Thus, to trade volatility with options, I believe traders have to consider how the underlying asset’s volatility affects the option’s value.

What Is the Volatility of an Option?

In my experience, volatility is one of the biggest factors affecting pricing options. And Investopedia agrees. This is because, unlike other factors, volatility is an estimate, the only unknown variable out of all other variables that determine options pricing.

Volatility is the price fluctuation of the underlying asset. It is the rate of change in the price of security in any market direction. If the rate of change is relatively stable, the stock has low volatility. Conversely, the stock is highly volatile if its price fluctuates quickly. For instance, an underlying stock (say AMZN) has low volatility if its price remains at $113 for a while, then moves slightly to $115 and stays that way for days before returning to close at $113 by the end of the week. The rate of change is relatively stable; it is not erratic. However, if AMZN moves from $113 to $120, drops to $118, and even drops further to $117 before closing at $120, this would demonstrate higher volatility. Its price movement is erratic and fluctuates quickly.

As mentioned, highly volatile assets are less desirable to investors who are “long” because of their risk. Conversely, periods of high volatility can provide exceptional returns for those selling put options and covered calls.

Cryptocurrencies have emerged as an interesting exception, though, with crypto investors using profitable strategies such as margin trading to take profit in bull, bear, and sideways market conditions. However, for the options market, it is another ball game. Volatility affects options pricing differently.

How Does Volatility (and Other Variables) Affect Option Prices?

Volatility positively impacts the price movements of options. But to appreciate the relationship between volatility and options pricing, it’s necessary to look at two variables that affect option prices briefly. These are the stock price and the exercise price (the predetermined price at which the trader buys the underlying asset after exercising the option).

Options Pricing and Stock Pricing

An increase in the stock price positively impacts the cost or premium of a call option while reducing the valuation of a put option. If the stock price increases, the call option has a higher chance of expiring in-the-money. Thus, when appropriate, the trader can exercise a call option to buy the asset at a lower price (the strike price), then sell at the increased market price. On the other hand, an increase in the price of a stock increases the chances a put option will expire out-of-the-money. If that happens, it expires worthless.

Options Pricing and Strike Pricing

Also, an increase in the strike price makes a call option less valuable. And similarly, it increases put option premiums. A higher strike price reduces a call option’s potential profitability. Conversely, a higher strike price increases a put option’s premium.

Options Pricing and Volatility

Volatility has the same effect on all options: the higher the volatility, the higher the option price. Of all the greeks that affect or determine option prices (perhaps except the expiration date), only volatility correlates positively with option prices. The expiration date also influences, but it is a function of volatility. The longer the expiration, the higher the chance of the stock price swinging in your desired direction.

Is Volatility Good for Options?

Since stock volatility is a measure of price fluctuation, high volatility means the asset has a higher probability of swinging to the upside or downside, thus increasing the chance of the option to be in-the-money. Generally, call or put options of highly volatile assets have high premiums, while low-volatility assets have low premiums. Examples of low-volatility assets can be found on the dividend kings list, among others.

To trade volatility with options, traders often look at two types: historical volatility and implied volatility.

Historical vs. Implied Volatility

Historical volatility examines the volatility of the underlying asset over a period. They use this to predict the future volatility of the asset. Historical volatility informs traders about the speed of volatility; however, it gives no information about the direction. For example, considering the prices of AMZN, the trader only knows that, in the first case, AMZN does not fluctuate much. Its rate of change is slow. And in the second case, its rate of change is faster.

But since options trading is placing a bet on the direction of change, it is crucial to know not only historical volatility but, more importantly, the direction of change. This is where implied volatility comes in.

Implied Volatility

Implied volatility is a more robust and efficient tool. It enables one to predict the asset’s price in real-time as it trades. It measures the expected volatility of the asset influenced by sentiments. Unlike historical volatility that predicts price movement from past trends, implied volatility factors in variables such as market dynamics, industry trends, and company news.

Usually, market downturns increase implied volatility, while uptrends cause implied volatility to drop. This is so because traders expect a trend reversal and a price rally in the future during a downtrend. Similarly, during uptrends, traders do not anticipate a greater price movement than what is already obtainable in the market, so, implied volatility falls.

Since implied volatility is all about traders’ expectations, what guides these expectations? What factors determine implied volatility? Where does implied volatility come from?

Where Does Implied Volatility Come from?

Two factors usually determine implied volatility in an options market. They are (1) supply and demand and (2) the time value of the option.

Demand correlates positively with implied volatility. The higher the demand, the higher the price of the underlying asset. And as the valuation of the underlying stock increases, traders expect a higher chance of profitability. On the other hand, low demand would cause the stock’s valuation to drop.

An option’s time value is another determinant of implied volatility. It is the amount of time left before the option expires. The longer the time, the higher the implied volatility — and vice versa. An option with a long time until expiration has a higher chance of swinging in any direction for profitability.

Implied Volatility and Option Prices

Understanding how implied volatility impacts option premiums requires understanding the components that make up an option’s price.

Option Pricing Components

An option seller can ask whatever they want for an option – but the premium paid is ultimately determined through two components: the option’s intrinsic value and time value.

Intrinsic Value

This measures an option’s profitability through the relationship (the difference) between the underlying asset’s current price and the strike or exercise price. The intrinsic value is a partial indicator of an option’s profitability. It tells the option trader the moneyness of the option. That is, whether the option contract is in-the-money, at-the-money, or out-of-the-money. This determines the option’s price.

Simple formulas for calculating the intrinsic value for call and put options are:

• Intrinsic Value (Call Option) = Market price of the asset – Strike price
• Intrinsic Value (Put Option) = Strike price – The market price of an asset  

A call option is in-the-money when the underlying’s price is above the strike price, out-of-the-money when the current price is below the strike price, and at-the-money when the market price and strike price are equal. Similarly, a put option is in-the-money when the market price is below the strike price, out-of-the-money when the market price is above the strike price, and at-the-money when the market and strike prices are equal. 

Time value

NASDAQ defines this as the component that determines an option premium based on the time left before the expiration of the option contract. They further explain that this component takes cognizance of the factors determining an option’s price may change within the expiration period.

As the expiration date draws close, the valuation of the option contract decreases. An option with three months to expiry has more time value than one with three weeks to expiry. The time value of an option is calculated as the difference between the option premium and its intrinsic value. 

Take Advantage of Volatility with These Option Trading Strategies

To take advantage of volatility, options traders would short (sell) options when the implied volatility is high and buy options (go long) when the implied volatility is low. There are trading strategies that allow traders to harness volatility. These options strategies are complex and are used by expert traders. They include short straddles and strangles, ratio writing, short call options, and buying put options (going long).

Short Straddles and Strangles

Investors use a straddle or strangle when uncertain about the direction of the volatility. Therefore, they combine two options so that the effect of one is neutralized by the other. 

Short straddle

Opposed to a long straddle strategy, a short straddle involves writing a call option and a put option simultaneously at the same exercise price and expiry date. For example, a trader can write a call and a put option for AMZN stock, currently traded at $113. If the call and put options are worth $8 and $6, each with a strike price of $113, what would be the outcome of the investment?

The options trader will make maximum profit only if both options expire at-the-money, and this profit equals the total premium received for both options. If AMZN moves above or below the strike price, the trader risks losing their investment. When AMZN swings above the strike price, the option writer will lose out on the call option but gain from the put option. And if AMZN swings below the strike price, the option writer would profit from the call option but lose out on the put option.

Short strangle

On the other hand, a short strangle involves writing a call option and a put option with the same expiry date but different strike prices. The call option’s strike price is usually higher than the current stock price, while the put option’s strike price is lower than the stock price. Back to the AMZN stock trading at $113. If a trader writes an $8 call option with an exercise price of $117 and a $6 put option with an exercise price of $108, what would be the outcome of the investment?

The option seller will make a maximum profit if AMZN trades between the two strike prices (i.e., $109 – $116). Both options are out-of-the-money, making the profit the net premium received for the options. 

Ratio Writing

This is a strategy where the trader simultaneously holds an unequal number of long and short options in a specific ratio. In my experience, a common ratio is 2:1, meaning that there are twice as many short options as long ones. The trader aims to take advantage of a drop in implied volatility.

If a trader longs an $8 call for AMZN with an exercise price of $103 and shorts two calls worth $6 each with a strike price of $113, they will receive a net premium of $4. That is, the premium received from the two written calls minus the premium paid for the long call. Furthermore, the trader would make a maximum profit if AMZN closed at $113 at expiration because the two written calls would expire worthlessly, and the trader would keep the net premium from both calls. They would also make a profit of $10 from the long call. Thus, the net profit accrued from this strategy would be (10 + 12) = $22.

Short Call Options

A trader can short or sell a call option if they are bearish about the market. The trader can only profit with this strategy if the option expires worthless. If this is the case, the trader keeps the option premium as profit. For example, if the trader anticipates a market downturn, they could write a $113 call option for AMZN worth $12. If the AMZN trades below $113 at expiration, the trader keeps the $12 premium. However, if AMZN trades above $113, the trader is obligated to sell the underlying asset at the strike price, resulting in a loss.

Long Put Options

Similar to the trader who shorts a call, a trader who longs a put also has a bearish sentiment toward the market. This means that the trader has the obligation to sell the asset at the strike price if the valuation of the asset drops. If the trader longs a $113 put for AMZN and the stock trades lower than $113 at expiration, the trader makes a profit by buying at the decreased stock price and selling at the strike price of $113.

Using Implied Volatility to Determine Nearer-term Potential Stock Movements

Implied volatility is a parameter that shows how large the expected price movement (the standard deviation) will be within a certain period. Implied volatility is used to determine standard deviation because it estimates future price movement. The formula for calculating one standard deviation move over the life of an option is given as follows:

1 standard deviation = (stock price) x (implied volatility) x √(days to expiration/252)

Notes:

1. Stockbrokers often assume that there are 252 trading days in a year.
2. The empirical rule predicts that for a normal distribution, 68% of the observed values falls within the first standard deviation from the mean.

Consider this example: if AMZN trades at $113, has an implied volatility of 30%, and has 19 days left until the expiration of the option, how much would the stock price move within this period?

1 standard deviation = (stock price) x (implied volatility) x √(days to expiration/252),

and 1 standard deviation = (113) x (0.3) x √(19/252),

so, 1 standard deviation = $9.31

This means that there is a 68% chance that AMZN will trade at 113 ± 9.31 until the period of expiration. That is, it will trade between $103.69 and $122.3.

However, there is a quick and dirty method to arrive at this solution without going through the rigors of calculation.

Quick and Dirty Formula for Calculating a One Standard Deviation Move Over the Life of an Option

By using an option chain, one can estimate one can compute the standard deviation without using the formula above. An option chain is a log of options contracts outlining their expiration, exercise price, volume, and other parameters relevant to the option.

To find the standard deviation, estimate the price of the at-the-money straddle and that of the out-of-the-money strangle. Sum the prices and divide by 2. This gives a 50% probability move.

For example, using an option chain found on NASDAQ, the price of $113 straddle for AMZN is estimated to be 3.35 and that of 103/123 strangle is estimated at 10. Adding these together and dividing by 2 equals 6.68. This means there is a 50% chance that AMZN will trade at 113 ± 6.68 until the expiration period. That is, it will trade between $106.32 and $119.68.

Final words

“Buy low, sell high.” This is the basic principle of any investment. This principle is rooted in a quality common to all forms of investment: volatility. Therefore, a winning options trader can successfully harness volatility.

This article Make A Killing Trading Volatility with Options originally appeared on Rick Orford - Invest, Earn More Income & Save Money.