There are seven aspects or variables that determine the value of an option. Of those seven variables, six have known values, and there isn’t any ambiguity about their input values into an option pricing model. However the seventh variable—volatility—is simply an estimate, and for that reason, it’s a very powerful consider determining the value of an option.

• The present price of the underlying – known
• Strike price – known
• Form of option (Call or Put) – known
• Time to the expiration of the choice – known
• Risk-free rate of interest – known
• Dividends on the underlying – known
• Volatility – unknown

Historical vs. Implied Volatility

Volatility can either be historical or implied; each are expressed on an annualized basis in percentage terms. Historical volatility (HV) is the actual volatility demonstrated by the underlying over a time frame, akin to the past month or yr. Implied volatility (IV), alternatively, is the extent of volatility of the underlying that’s implied by the present option price.

Implied volatility is much more relevant than historical volatility for options’ pricing since it looks forward. Consider implied volatility as peering through a somewhat murky windshield, while historical volatility is like looking into the rearview mirror. While the degrees of historical and implied volatility for a selected stock or asset could be and infrequently are very different, it makes intuitive sense that historical volatility could be a very important determinant of implied volatility, just because the road traversed may give one an idea of what lies ahead.

All else being equal, an elevated level of implied volatility will lead to the next option price, while a depressed level of implied volatility will lead to a lower option price. For instance, volatility typically spikes across the time an organization reports earnings. Thus, the implied volatility priced in by traders for this company’s options around “earnings season” will generally be significantly higher than volatility estimates during calmer times.

Volatility, Vega, and More

The “Option Greek” that measures an option’s price sensitivity to implied volatility is often called Vega. Vega expresses the value change of an option for each 1% change in volatility of the underlying.

Two points must be noted with regard to volatility:

• Relative volatility is beneficial to avoid comparing apples to oranges in the choices market. Relative volatility refers back to the volatility of the stock at present in comparison with its volatility over a time frame. Suppose stock A’s at-the-money options expiring in a single month have generally had an implied volatility of 10%, but at the moment are showing an IV of 20%, while stock B’s one-month at-the-money options have historically had an IV of 30%, which has now risen to 35%. On a relative basis, although stock B has greater absolute volatility, it is obvious that A has had a much bigger change in relative volatility.
• The general level of volatility within the broad market can also be a very important consideration when evaluating a person stock’s volatility. The perfect-known measure of market volatility is the Cboe Volatility Index (VIX), which measures the volatility of the S&P 500. Also often called the fear gauge, when the S&P 500 suffers a considerable decline, the VIX rises sharply; conversely, when the S&P 500 is ascending easily, the VIX will probably be becalmed.

Probably the most fundamental principle of investing is buying low and selling high, and trading options isn’t any different. So option traders will typically sell (or write) options when implied volatility is high because that is akin to selling or “going short” on volatility. Likewise, when implied volatility is low, options traders will buy options or “go long” on volatility.

Based on this discussion, listed here are five options strategies utilized by traders to trade volatility, ranked so as of accelerating complexity. As an instance the concepts, we’ll have a look at a historical example using Netflix Inc. (NFLX) options.

Buy (or Go Long) Puts

When volatility is high, each by way of the broad market and in relative terms for a selected stock, traders who’re bearish on the stock may buy puts on it based on the dual premises of “buy high, sell higher,” and “the trend is your friend.”

For instance, Netflix closed at $91.15 on Jan. 27, 2016, a 20% decline year-to-date, after greater than doubling in 2015, when it was the perfect performing stock within the S&P 500. Say that traders who were bearish on the stock could buy a $90 put (i.e. strike price of $90) on the stock expiring in June 2016. The implied volatility of this put was 53% on Jan. 29, 2016, and it was offered at $11.40. Which means Netflix would have had to say no by $12.55 or 14% from those starting levels before the put position became profitable.

This strategy is an easy but relatively expensive one, so traders who want to cut back the associated fee of their long put position can either buy an additional out-of-the-money put or can defray the associated fee of the long put position by adding a brief put position at a lower cost, a technique often called a bear put spread.

Continuing with the Netflix example, a trader could have bought a June $80 put at $7.15, which was $4.25 or 37% cheaper than the $90 put on the time. Or else the trader could have looked to a bear put spread by buying the $90 put at $11.40 and selling (writing) the $80 put at $6.75 (note that the bid-ask for the June $80 put was thus $6.75 / $7.15), for a net cost of $4.65.

Write (or Short) Calls

A trader who was also bearish on the stock but thought the extent of implied volatility for the June options could recede might need considered writing naked calls on Netflix with the intention to pocket a premium of over $12. Assume that the June $90 calls had a bid-ask of $12.35/$12.80 on Jan. 29, 2016, so writing these calls would lead to the trader receiving a premium of $12.35 (i.e. receiving the bid price).

If the stock closed at or below $90 by the June 17 expiration of those calls, the trader would have kept the complete amount of the premium received. If the stock closed at $95 just before expiration, the $90 calls would have been price $5, so the trader’s net gain would still be $7.35 (i.e. $12.35 – $5).

The Vega on the June $90 calls was 0.2216, so if the IV of 54% dropped sharply to 40% (i.e., 14 vols) soon after the short call position was initiated, the choice price would have declined by about $3.10 (i.e. 14 x 0.2216).

Note that writing or shorting a unadorned call is a dangerous strategy, due to the theoretically unlimited risk if the underlying stock or asset surges in price. What if Netflix soared to $150 before the June expiration of the $90 naked call position? In that case, the $90 call would have been price at the very least $60, and the trader could be a big 385% loss. With a view to mitigate this risk, traders will often mix the short call position with an extended call position at the next price in a technique often called a bear call spread.

Short Straddles or Strangles

In a straddle, the trader writes or sells a call and put at the identical strike price with the intention to receive the premiums on each the short call and short put positions. The rationale for this strategy is that the trader expects IV to abate significantly by option expiry, allowing most if not the entire premium received on the short put and short call positions to be retained.

Again using the Netflix options for example, writing the June $90 call and writing the June $90 put would have resulted within the trader receiving an option premium of $12.35 + $11.10 = $23.45. The trader was banking on the stock staying near the $90 strike price by the point of option expiration in June.

Writing a brief put imparts on the trader the duty to purchase the underlying on the strike price even when it plunges to zero while writing a brief call has theoretically unlimited risk as noted earlier. Nonetheless, the trader has some margin of safety based on the extent of the premium received.

In this instance, if the underlying Netflix stock closed above $66.55 (i.e. strike price of $90 – premium received of $23.45), or below $113.45 (i.e. $90 + $23.45) by option expiry in June, the strategy would have been profitable. The precise level of profitability relied on where the stock price was by option expiry; profitability was maximized at a stock price by expiration of $90 and reduced because the stock gets further away from the $90 level. If the stock closed below $66.55 or above $113.45 by option expiry, the strategy would have been unprofitable. Thus, $66.55 and $113.45 were the 2 break-even points for this short straddle strategy.

A brief strangle is comparable to a brief straddle, the difference being that the strike price on the short put and short call positions usually are not the identical. As a general rule, the decision strike is above the put strike, and each are out-of-the-money and roughly equidistant from the present price of the underlying. Thus, with Netflix trading at $91.15, the trader could have written a June $80 put at $6.75 and a June $100 call at $8.20, to receive a net premium of $14.95 (i.e. $6.75 + $8.20). In return for receiving a lower level of premium, the danger of this strategy was mitigated to some extent. It’s because the break-even points for the strategy became $65.05 ($80 – $14.95) and $114.95 ($100 + $14.95) respectively. 

Ratio Writing

Ratio writing simply means writing more options than are purchased. The only strategy uses a 2:1 ratio, with two options, sold or written for each option purchased. The rationale is to capitalize on a considerable fall in implied volatility before option expiration.

A trader using this strategy could have purchased a Netflix June $90 call at $12.80, and write (or short) two $100 calls at $8.20 each. The web premium received on this case was thus $3.60 (i.e. $8.20 x 2 – $12.80). This strategy is similar to a bull call spread (long June $90 call + short June $100 call) with a brief call (June $100 call). The utmost gain from this strategy would accrue if the underlying stock closed exactly at $100 shortly before option expiration. On this case, the $90 long call would have been price $10 while the 2 $100 short calls would expire worthlessly. The utmost gain would, due to this fact, be $10 + premium received of $3.60 = $13.60.

Ratio Writing Advantages and Risks

Let’s consider some scenarios to guage the profitability or risk of this strategy. What if the stock closed at $95 by option expiry? On this case, the $90 long call would have been price $5 and the 2 $100 short calls would expire worthless. The entire gain would, due to this fact, have been $8.60 ($5 + net premium received of $3.60). If the stock closed at $90 or below by option expiry, all three calls expired worthless and the one gain would have been the web premium received of $3.60.

What if the stock closed above $100 by option expiry? On this case, the gain on the $90 long call would have been eroded by the loss on the 2 short $100 calls. At a stock price of $105, for instance, the general P/L would have been: $15 – (2 X $5) + $3.60 = $8.60

Break-even for this strategy could be at a stock price of $113.60 by option expiry, at which point the P/L could be: (profit on long $90 call + $3.60 net premium received) – (loss on two short $100 calls) = ($23.60 + $3.60) – (2 X 13.60) = 0. Thus, the strategy could be increasingly unprofitable if the stock rose above the break-even point of $113.60.

Iron Condors

In an iron condor strategy, the trader combines a bear call spread with a bull put spread of the identical expiration, hoping to capitalize on a retreat in volatility that may lead to the stock trading in a narrow range throughout the lifetime of the choices.

The iron condor is constructed by selling an out-of-the-money (OTM) call and buying one other call with the next strike price while selling an in-the-money (ITM) put and buying one other put with a lower strike price. Generally, the difference between the strike prices of the calls and puts is identical, they usually are equidistant from the underlying. Using Netflix June option prices, an iron condor might involve selling the $95 call and buying the $100 call for a net credit (or premium received) of $1.45 (i.e. $10.15 – $8.70), and concurrently selling the $85 put and buying the $80 put for a net credit of $1.65 (i.e. $8.80 – $7.15). The entire credit received would, due to this fact, be $3.10.

The utmost gain from this strategy was equal to the web premium received ($3.10), which might accrue if the stock closed between $85 and $95 by option expiry. The utmost loss would occur if the stock at expiration was trading above the $100 call strike or below the $80 put strike. On this case, the utmost loss could be equal to the difference within the strike prices of the calls or puts respectively less the web premium received, or $1.90 (i.e. $5 – $3.10). The iron condor has a comparatively low payoff, however the tradeoff is that the potential loss can also be very limited.

The Bottom Line

These five strategies are utilized by traders to capitalize on stocks or securities that exhibit high volatility. Since most of those strategies involve potentially unlimited losses or are quite complicated (just like the iron condor strategy), they need to only be utilized by expert options traders who’re well versed with the risks of options trading. Beginners should stick with buying plain-vanilla calls or puts.