Buying and Selling Volatility, Part II

Please refer to Part 1 for an introduction to volatility-based trading (V-trading for short).

Tools of the V-Trade

Please excuse this repetition, but I feel it's essential for a complete understanding of the subject.

We measure how expensive or cheap options are using a parameter called implied volatility, or IV for short. The term implied volatility comes from the fact that options imply the volatility of their underlying, just by their price. A computer model starts with the actual market price of an option, and measures IV by working the option fair value model backward, solving for volatility (normally an input) as if it were the unknown. (Actually, the fair value model cannot be worked backward, and has to be worked forward repeatedly through a series of intelligent guesses until the volatility is found which makes fair value equal to the actual market price of the option.)

Again, high IV is synonymous with expensive options; low IV is synonymous with cheap options. It is useful to plot an asset’s IV over a period of years, to see the extent of its highs and lows, and to know what constitutes a normal, or average level.

We measure how much the price of an asset bounces around using a parameter called statistical volatility, or SV for short. There are several different computer models for measuring SV. All of them seek to quantify the extent, or magnitude, of the asset’s price swings on a percentage basis, and use varying periods of the asset’s recent price history (for example, 10, 20 or 30 days). SV can also be plotted, so that the investor can see the periods of relative price activity and inactivity over time.

Note: Much of the industry calls this historical volatility, but we prefer to call it statistical volatility, reserving the word historical for its true meaning – that of referring to the history of IV and SV.

Regardless of the length of the sample period, SV is always normalized to represent a one-year, single standard deviation price move of the underlying asset. IV is also normalized to the same standard. Thus IV and SV are directly comparable, and it is very useful to see them plotted together.

The High Road

When the options of a particular asset are more expensive than usual, sometimes that additional expense is justified by unusually high volatility in the underlying. While this may be a decent opportunity to sell options, it is even more advantageous to sell options when the extra IV is not accompanied by extra SV. One example of this, at the time of this writing, was the gold/silver index (XAU) (see figure 1). In this example, IV (represented by the dashed line) is at a relatively high level. At the same time, these high IV levels would not seem to be supported, or justified, by a correspondingly high SV.

Clearly, the advantage is with the trader who sells this high volatility, and that means selling options. Generally, any position in which you are short more options than you are long is short volatility. The purest selling strategy is a naked strangle, which involves selling out-of-the-money calls and out-of-the-money puts. Some like to buy farther out-of-the-money calls and puts at the same time for protection (thus creating credit spreads), but this considerably weakens the position’s vega, or volatility sensitivity. We want a substantial vega, so that when IV eventually comes down, our position makes money.

Out-of-the-money options are preferable because it gives the underlying some room to wander, and increases the likelihood of realizing a profit. Generally, the farther out-of-the-money you go, the lower your returns, but the greater the probability of achieving those returns. By giving the underlying room to move, the trader minimizes his chances of having to make costly adjustments.

I use the longest-term options I can get, provided they have decent liquidity. Longer term options have higher vega, and will therefore respond best when IV comes down. Longer term options have the additional advantage of having lower “gamma”. Gamma measures how fast delta changes with price changes in the underlying. By using lower gamma options, it takes a bigger price change in the underlying to imbalance your position.

One other strategy for selling options (but which cannot apply to index options, unfortunately) is covered writing, which involves buying stock, or futures contracts, and selling calls. However, covered writing is not delta neutral, and since it usually involves the ownership of a portfolio of stocks, is in a camp by itself. There are many mutual funds and individually managed covered writing programs. Managers of these funds would do well to pay attention to IV levels in timing the sale of their calls.

The Low Road

Low volatility situations can be just as lucrative. I have heard arguments against buying options, based on the idea that time decay is against you. Time decay is a funny concept. Do you remember using “imaginary numbers” in math class to deal with the square roots of negative numbers? Time decay (or theta) is kind of like that. It’s an imaginary number. It says that if the underlying asset’s price holds perfectly still, the option will decay at a certain rate. But what underlying asset price holds still? None, obviously. In fact, time is what gives the asset its freedom to move!

I may have a short volatility position, and let’s say it has a theta of 100. This means I’m making $100 dollars per day from time decay. Should I feel gratified to see this? Not really. It’s a false gratification because today’s movement in the underlying could take away $100, or perhaps many times that.

There is nothing wrong with buying options. When an option is fairly valued, by definition there is no advantage to the buyer nor the seller. If you buy a fairly valued option, you have not taken on a latent disadvantage in the guise of “time decay”. Why? Because the underlying is in constant motion.

An example of extremely low volatility right now is Orange Juice (see figure 2). Current IV is approximately 25%, way below normal levels and the lowest it's been in four years. Based on a computer simulation, when Orange Juice’s IV returns to a more normal 28 - 42%, the long dated Orange Juice options will double in price. Thus a straddle purchase is recommended.

When buying options, it makes more sense to buy near-the-money, although it doesn’t have to be a pure straddle (call and put at the same strike). That way a sharp move in the underlying has a better chance of helping the position. When that happens, not only does IV normally get a boost, but the move may drive one of the sides deep in-the-money and give you a gain just from price movement.

Of course, this awaited price activity might not happen right away, but since the options in question have more than 300 days to go, you’ll have plenty of time. You might even say that time is on your side! (Surely it won’t take that long before we see higher levels.)

It is interesting that long volatility positions have a completely different “feel” than short volatility positions. Short volatility positions often gratify the holder with steady, almost daily, gains, but can suddenly lose money if the underlying makes a sharp move. Long volatility positions often seem to dribble away value day by day for many weeks, and suddenly gain very quickly. Despite their opposite psychological effects, a mix of both types of positions belong in the V-trader’s portfolio.

Deciding when to close a long volatility position is usually more difficult, since the position has blossomed into a larger position with a sharp move in the underlying, and has probably become imbalanced. Often there is the potential to make (or lose) more money with each additional day that you hold the position. What can help you make a decision is to identify whether volatility has returned to normal levels. If it has, you should consider closing the position. If it has not, you might consider continuing with an adjusted (re-balanced) position.

When buying volatility, just as when selling volatility, use the longest dated options you can find that give you decent liquidity. The reason is the same as when selling: high vega. The long dated options, with their higher vega, will respond the best when IV increases.

There are other variations on the volatility game. For example, some watch individual stocks relative to their industry group and play high and low ones against each other.

Next time I'll discuss volatility skew -- what it is and how you can take advantage of it.