The Volatility Edge in Options Trading
In the option market, traders must exploit every edge they can find. One significant statistic that often goes unnoticed among beginning traders is volatility. By understanding the effect of volatility on option prices, option traders can gain an edge in the markets.
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Option Pricing
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Options are priced based on several factors. These include the price of the underlying security, option strike price, time until expiration and volatility. Option price statistics are represented by the option "greeks" of Delta, Gamma, Theta and Vega. Vega is the statistic that measures how much an option's price changes in response to a 1 percent increase in market volatility.
Effect of Volatility
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Volatility is basically a measure of how much prices move up or down in a given time period. High volatility drives option prices up. The reason for this is that high volatility increases the likelihood that an option will expire in the money.
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Gaining an Edge
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The way to gain an edge in options trading by using volatility is to buy on low volatility and sell on high volatility. All else being equal, options trading during times of low volatility are essentially trading at bargain prices while options trading on high volatility are trading at premium prices. Therefore, a trader looking to gain a volatility edge will anticipate future changes in volatility and make option trades accordingly.
Trading Strategies
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In addition to simply buying on low volatility and selling on high volatility, there are specific strategies that traders can use to take advantage of volatility. One such strategy is the long strangle. In a long strangle, the trader simultaneously purchases a near the money call option and a near the money put option. This strategy is direction neutral and is designed to profit from an increase in market volatility.
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