Why you need to understand volatility
Chris McKhann | [email protected]
All options have a volatility expectation priced into their premiums. If you are buying a call, for instance, you are betting on the direction of the underlying stock but are also betting that its volatility will be greater than that implied by the option's price.
That is why new traders often have the experience of buying an option, being right on the direction, and still losing money. This usually happens around earnings announcements, as the volatility expectations before those events get priced higher. And those expectations--the implied volatility of the option premiums--then tumble after the event.
Most professional option traders focus primarily on volatility rather than a specific direction. Many of them believe that it is easier to get an edge this way because volatility is mean-reverting and often appears mispriced.
We saw this type of trading a few weeks back in homebuilder D.R. Horton and broadband company Liberty Global. In both cases the trade involved the sale of puts and then the subsequent sale of stock to create so-called delta-neutral positions that are short volatility.
In DHI, a trader sold 5,000 August 21 puts for $1.30 and then sold 160,000 shares for $22.8063. The implied volatility of the puts was 37 percent, while the stock's 20-day historical volatility was 22 percent.
In LBTYA, a block of 3,000 April 42.50 puts was for $0.75. Another 105,000 shares were sold for $43.50 shortly after.
All options have a delta, which represents the change in the price of the option given a $1 change in the price of the underlying stock. So if a call has a delta of 0.50, the option will gain $0.50 if the stock goes up $1. For LBTYA, the total delta of the put position is 105,000 - 3,000 x 0.35 x 100 (100 is the option multiplier, because 1 option controls 100 shares of stock).
Both of these trades are short volatility, which is a favorite of hedge funds. I have seen studies that the average hedge fund could be replicated by having a portfolio of 50 percent S&P 500 and 50 percent short volatility (though of course there is no hedging going on there, as both will get hurt in declining markets).
Options tend to carry a volatility risk premium, which funds love to collect. Some critics, however, have likened such trades to "picking up nickels in front of a steamroller."
Short-volatility strategies are betting that a stock will remain range-bound and/or that the actual volatility of the shares will be lower than what is implied by the option premium.
If the trade is left untouched, it could profit only with the stock in a tight range around the strike of the sold option. But if the volatility seller continues to delta-hedge the position, the stock can trend in one direction or the other and the trader could still profit as long as the actual volatility is lower than the implied volatility of the option.
All of this may well be confusing at first, but remember: Every option trader is a volatility trader. So understanding the basic dynamics of what that means will help you be more profitable.
(A version of this article appeared in optionMONSTER's Advantage Point newsletter.)