Option & Volatility Trading Strategies

Investors capture volatility to profit regardless of market direction.

Volatile markets create potentials for making money regardless of market direction. Understanding how to capture and profit from volatility requires understanding how to price options and assess volatility. Knowing how to assess risk/reward characteristics of market conditions to calculate expected return requires an understanding of the types of volatility and how they affect the market.

Measuring Volatility

Traders identify opportunities and assess volatility by measuring underlying prices and options values with "the Greeks."

A stock's "beta" measures its risk against others. Beta ratios of 1 or more mean a stock's volatility, or price swings, are higher than most others.

"Delta." When measuring an option call, Delta of .75 means a 3/4-point premium increase for every point stock price increases. In a put options, investors make money when stocks decline. When options approach expiry, Delta climbs closer to 1.

Delta tracks incremental movements in the underlying stock. Evaluating "Gamma" can confirm Delta changes. If Gamma changes by 0.175, Delta will also change by 0.175 when the underlying price rises or falls approximately 1 point.

Traders evaluate leverage: "Lambda" shows anticipated percentage change in an option's value for every 1 percent change in the underlying.

Interest rates affect option values: "Rho" reflects option value changes for each percent change in interest rates. Rho of 0.50 percent projects the option's value will increase by an approximate amount when interest rates decrease by 1 percent.

Volatility of option values change with time: all options have price and time values. "Theta" reflects the option's value change for each unit--or seven-day period--decrease to contract expiration. Theta of -500 indicates an option's hypothetical or theoretical value will also change by -500 with each time unit. Theta unit changes close to option expiration, at seven or fewer days.

Traders measure an option value's change in relation to volatility with "Vega" (kappa, tau, omega). Vega reflects option value change for each 1 percent increase or decrease in volatility. Vega of .080 means change of an option's theoretical value increases by .080 when volatility rises by 1 percent. Similarly, when volatility percentage decreases by 1 percent, theoretical value decreases by .080.

Volatility Trading Resources

Learn more about how to construct and measure volatility trades with the CBOE Options Trade Tool box. The Options Industry Council also provides volatility trading resources.

Hedging Volatility

All investors should consider volatility. Hedging stock positions, using buy-write strategies, captures vol:

You own GHI Bottling Company and believe long-term potential remains positive. Short-term, you believe the stock will maintain a narrow trading range. At $10 a share, consider the following:

1) Sell GHI calls at $11 at 0.50 for 3 months. If GHI continues to trade at $10-10.50, the option expires worthless and you capture the premium.

2) If GHI falls to $9.75, the option expires worthless and you capture the premium.

3) GHI rises to $11.25 during the contract period. Your stock is "called" and sold at $11. You capture premium and book profit according to cost basis.

References

• Investopedia: stock beta
• CBOE: how to capture and profit from volatility
• This Matter: "the Greeks"
• CBOE: Options Trade Tool
• Options Industry Council: Options Strategies: Collars

Resources

• "Volatility and Correlation: the Perfect Hedger and the Fox"; Riccardo Rebonato; 2004
• Options Industry Council: Strategies: Getting Started
• "The Volatility Edge in Options Trading"; Jeff Augen; 2008
• "Volatility Trading"; Euan Sinclair; 2009
• "An Analysis of the Implications for Stock and Futures Price Volatility ... Dynamic Hedging"; Sanford Grossman; 1989