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Seven factors have an impact on options price. These seven factors are; the current price of the underlying, Strike price, Type of option (Call or Put), Time to the expiration of the option, risk-free interest rate, Dividends on the underlying, and Volatility. In one of our previous blogs, we have explained the factors affecting options price.
Except for volatility all other factors have known value. Therefore it becomes easy to estimate the effect of these factors on options price. But volatility is the factor that has no fixed value. Therefore, it becomes necessary to learn about options volatility and pricing strategies. When you first learned about options you probably learned about the options Greeks Delta, Gamma, Theta, Vega, and Rho from there you probably honed in on Delta. That's because many of the most commonly taught options strategies are driven primarily by the direction and the price of the underlying. But if you're only focusing on price moves you may be missing out. If you want to create trades with more flexibility and precision implied volatility can be key. It can help you choose strategies and see trade opportunities beyond price movement. Therefore here we have come up with a dedicated blog on options volatility and pricing strategies.
This blog covers,
What is volatility trading?
Volatility options strategies
How to use implied volatility for options buying
How to use implied volatility for options selling
What is volatility trading?
Volatility is the measure of price change in options price over a specific period. Let’s understand Historical and Implied Volatility shortly before understanding what is volatility trading. Volatility is expressed in percentage terms and is calculated on an annual basis. Historical volatility (HV) measures the price changes of the underlying over a period especially of the past month or year. The higher the historical volatility riskier the options is. Whereas Implied volatility (IV) is the level of volatility of the underlying that is implied by the current option price. Implied volatility is the expected volatility of a stock over the life of the option. Lower the implied volatility cheaper is the option price, as lower volatility options do not expect greater movements in price. Therefore implied volatility is more important than historical volatility when it comes to option volatility and pricing strategies. Option traders should know How to use implied volatility for option buying or selling.
So, let us answer the question: what is volatility trading? Any instrument like an option or security whose price keeps changing depending upon the circumstances has or exhibits volatility. Volatility trading refers to trading the volatility of a financial instrument rather than trading the price itself. Traders who do volatility trading don't get affected by the direction of price moves. They're simply trading the volatility, which means they trade on the possible price change of an instrument in the future. Now that you have got an idea about what is volatility trading. Let's move forward to Volatility options strategies.
What are Volatility options strategies?
Traders who are into volatility options trading do not worry about the direction of the options price movements. They earn a profit when volatility is high irrespective of the direction of price movement (i.e. up or down). When it comes to the volatility options strategies Straddle is the most popular strategy.
1. Straddle Strategy
This strategy focuses on making a profit and taking advantage of increased volatility in any price direction. This strategy gives profit when prices move strongly in any one direction i.e.up or down. Therefore this strategy proves to be the best when there are high volatility expectations in the market.
Trade Volatility with Options
When using options to trade volatility, a trader could buy a call option and a put option with the same strike price and expiration date. When you want to trade volatility with options the Straddle strategy can be effectively used with options as well.
If the underlying instrument experiences a large price-move, either the put or call option will become In-The-Money and return a profit. A rise in the price would make the call option In-The-Money, while a fall in the price would make the put option In-The-Money.
The following graphic shows how the Straddle strategy works with options of the same strike price and expiration date.
Along with the straddle strategy following are some more Volatility options strategies that are used by traders to capitalize on stocks or securities that has high volatility:
1. Iron Condors
An iron condor strategy involves combining a bear call spread with a bull put spread of the same expiration, in the hope of capitalization on a retreat in volatility that will result in the stock trading in a narrow range during the life of the options.
In iron condor strategy traders sell Out-of-The-Money (OTM) calls and buy another call with a higher strike price while selling an In-The-Money (ITM) put and buying another put with a lower strike price.
2. Ratio Writing
When a trader writes more options than are purchased then this is called Ratio writing. The simple ratio writing strategy uses a 2:1 ratio, with two options, sold or written for every option purchased. The rationale is to capitalize on a substantial fall in implied volatility before options expiration.
3. Buy (or Go Long) Puts
4. Write (or Short) Calls
Now that you have understood volatility and pricing strategies. If you want to know in-depth about some of the above options trading strategies then you can check out our blog in which we have explained all the options trading strategies.
Know about How to use implied volatility for options buying and How to use implied volatility for options selling?
Consider any down-trending stock XYZ and an option trader wants to make a bearish trade. He might consider buying a put or selling a call. Both are traditionally bearish strategies that are designed to profit from a downward price move. For the purpose of this example we'll hold off analyzing factors like cost and risks and use implied volatility to help assess which trade might be the best.
Generally speaking short options strategies like selling a call can benefit from falling implied volatility this makes sense since these trades have negative Vega and the goal is usually for the price the underlying to stay below the call strike in hopes that the options will expire worthless.
On the other hand long options strategies like buying a put can benefit from rising implied volatility. The goal is for the long options to gain value and these trades are Vega positive. Before we check what XYZ's implied volatility is doing. Remember that this number is relative. Some securities or industries are more volatile by nature. Rather than looking at the XYZ's overall implied volatility, we will want to focus on whether it is trading within its own volatility range or not. In the image we see XYZ is trading at the low end. It is more likely that implied volatility will increase then fall and that would benefit long options plus increasing implied volatility often accompanies downward moves in price. So this helps confirm traders the bearish outlook. Based on these factors our trader may choose to buy a put rather than selling a call. So all in all remember one thing when you get a question like How to use implied volatility for option buying then the answer will be; buy (Buy (or Go Long) Puts) an option when IV is low and when it comes to how to use implied volatility for option selling; sell (Write (or Short) Calls) an option when the volatility is high. You should note that writing or shorting a naked call is a risky strategy, as it theoretically has unlimited risk if the underlying stock or asset surges in price.
Conclusion
Besides the six factors affecting options price, the Options prices depend mainly on the seventh factor i.e. estimated future volatility of the underlying asset. Therefore volatility Trading becomes an important set of strategies used by options traders. We explained how to use implied volatility for options buying. By going through this blog you must have got an idea about Options volatility and pricing strategies. Most of these strategies involve potentially unlimited losses or are quite complicated. Therefore we advise you to use these Volatility options strategies only if you are an expert options trader who is well versed with the risks of options trading. If you are a beginner you should stick to buying plain-vanilla calls or puts. We hope that you have got a complete idea about how to use implied volatility for option selling. Remember one thing while trading volatility that always buy low and sell high.