Volatility Trading Strategy

On this page I introduce the concept of volatility trading strategies, and how to use it in several powerful and profitable option trading strategies.

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Volatility is incredibly important in the options world - it is the basis for all options pricing models, and it forms the core of several options trading strategies. Volatility ultimately determines whether your trade is going to be profitable or not, and it can also determine whether you get taken to cleaners or not. It is a measure of risk, but it is also a measure of potential. Volatility trading strategies are really useful ways of riding the risk wave, and making the trade work for you.

Volatility is a statistical measure of how the price of a stock is moving, and it has a direct effect on the price of options. It is also a measure of risk. Highly volatile stocks will fluctuate wildly, and often unpredictably, and so trading such a stock would be high risk. Because of this risk factor, option prices are higher. The opportunity for quick profit is much higher with volatile stocks, as is the risk of being trashed. This is both a threat and an opportunity.

Traders will typically look at the volatility of the overall market, which is measured by the VIX index. Often, when this is high, or when it spikes, a drastic (and often downwards) reversal is about to start. Volatility is often higher in a downward trending market than in an upward market, because traders are more likely to panic, and this is reflected in price fluctuations. When the market turns up, traders calm down, start being optimistic, put their antacids away, and keep steady - so volatility tends to drop (NB this is a major generalisation!!)

There are two ways of looking at volatility that are relevant to options traders:

1. Historical volatility - the measure of how the price of a stock has fluctuated over a recent period of time (e.g. 3 the last three months). Historical volatility is used in option pricing models (such as the Black-Scholes model) to determine the fair value of an option. Generally, the higher an equitys volatility, the higher the option prices will be. If your trading software shows the values for Option Greeks, then you would look at the VEGA to get a value for historical volatility.

2. Implied Volatility - a measure of the stock volatility that is implied by the actual trading price of an option. In other words, the Black Scholes model will take the price of an option contract, and from that derive a measure of how volatile the stock is. This is measured by the Greek symbol ZETA.

How does this affect Options Traders?

These measures can be used in dozens of ways by options traders, and give us some useful volatility trading strategies. For example, if you are into buying and selling calls, you will want to know whether the option that you are buying is cheap, at fair price, or expensive. In the ideal world, you would buy a cheap option, and a few days later, as the volatility spikes, you sell the option at a relatively higher price. Options Universitys Volcone Analyser Pro is an example of software that is used to assess this type of trade. When you are selling options, you need to aware of volatility, because you dont want to get knocked out of a trade by wild swings in the market.

Volatility Trading Strategies

There are two basic volatility trading strategies that work really well in highly volatile markets. Very often, you know that some significant moves are about to take place, but you are not sure what the direction will turn out to be. These two strategies give you the ability to make low risk - high reward trades without even having to get the direction right! Both of these strategies are direction neutral, and are fairly similar. The key difference is that one strategy needs a somewhat bigger initial investment, but has a correspondingly higher reward potential. So, if you are not sure about the direction of a stock, but your technical analysis indicates that a major move is imminent, you would do well to consider trading (buying) a STRADDLE or a STRANGLE.

If volatility is really low, and you are in a sideways market, you may consider SELLING a straddle or a strangle.

The Straddle is a bread and butter strategy, and simple to execute. The strangle is equally sound as a trading strategy, even if slightly less rewarding (and slightly less risky!). Both strategies are sensitive to time decay, so trading them means that you need to leave enough time so that you are not greatly affected by this.