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Usually, the higher an assets volatility, the higher the price of its optionsVOLATILITY Volatility measures market movement or nonmovement. It is defined as the magnitude by which an underlying asset is expected to fluctuate in a given period of time. As previously discussed, it is a major contributor to the price (premium) of an option; usually, the higher an assets volatility, the higher the price of its options. This is because a more volatile asset offers larger swings upward or downward in price in shorter time spans than less volatile assets. These movements are attractive to options traders who are always looking for big directional swings to make their contracts profitable. High or low volatility gives traders a signal as to the type of strategy that can best be implemented to optimize profits in a specific market. I like looking for wild markets. I like the stuff that moves, the stuff that scares everybody. Basically, I look for volatility. When a market is volatile, everyone in the market is confused. No one really knows whats going on or whats going to happen next. Everyone has a different opinion. Thats when the market is ripe for delta neutral strategies to reap major rewards. The more markets move, the more profits can potentially be made. Volatility in the markets certainly doesnt keep me up at night. For the most part, I go to bed and sleep very well. Perhaps the only problem I have as a 24-hour trader is waking up in the middle of the night to sneak a peek at my computer. If I discover Im making lots of money, I may stay up the rest of the night to watch my trade. As uncertainty in the marketplace increases, the price for options usually increases as well. Recently, we have seen that these moves can be quite dramatic. Reviewing the concept of volatility and its effect on option prices is an important lesson for beginning and novice traders alike. Basically, an option can be thought of as an insurance policywhen the likelihood of the insured event increases, the cost or premium of the policy goes up and the writers of the policies need to be compensated for the higher risk. For example, earthquake insurance is higher in California than in Illinois. So when uncertainty in an underlying asset increases (as we have seen recently in the stock market), the demand for options increases as well. This increase in demand is reflected in higher premiums. When we discuss volatility, we must be clear as to what were talking about. If a trader derives a theoretical value for an option using a pricing model such as Black-Scholes, a critical input is the assumption of how volatile the underlying asset will be over the life of the option. This volatility assumption may be based on historical data or other factors or analyses. Floor and theoretical traders spend a lot of money to make sure the volatility input used in their price models is as accurate as possible. The validity of the option prices generated is very much determined by this theoretical volatility assumption. Whereas theoretical volatility is the input used in calculating option prices, implied volatility is the actual measured volatility trading in the market. This is the price level at which options may be bought or sold. Implied volatilities can be acquired in several ways. One way would be to go to a pricing model and plug in current option prices and solve for volatility, as most professional traders do. Another way would be to simply go look it up in a published source, such as the Optionetics Platinum site. Once you understand how volatilities are behaving and what your assumptions might be, you can begin to formulate trading strategies to capitalize on the market environment. However, you must be aware of the characteristics of how volatility affects various options. Changes in volatility affect at-the-money option prices the most because ATM options have the greatest amount of extrinsic value or time premiumthe portion of the option price most affected by volatility. Another way to think of it is that at-the-money options represent the most uncertainty as to whether the option will finish in-the-money or out-of-the-money. Additional volatility in the marketplace just adds to that. Generally changes in volatility are more pronounced in the front months than in the distant months. This is probably due to greater liquidity and open interest in the front months. However, since the back month options have more time value than front month options, a smaller volatility change in the back month might produce a greater change in option price compared to the front month. For example, assume the following (August is the front month): August 50 calls (at-the-money) = $3.00; Volatility = 40% November 50 calls (at-the-money) = $5.00; Volatility = 30% Following an event that causes volatility to increase we might see: August 50 calls = $4.00; Volatility = 50% November 50 calls = $6.50; Volatility = 38% We can see that even though the volatility increased more in August, the November options actually had a greater price increase. This is due to the greater amount of time premium or extrinsic value in the November options. Care must be taken when formulating trading strategies to be aware of these relationships. For example, it is conceivable that a spread could capture the volatility move correctly, but still lose money on the price changes for the options. Changes in volatility may also affect the skew: the price relationship between options in any given month. This means that if volatility goes up in the market, different strikes in any given month may react differently. For example, out-of-the-money puts may get bid to a much higher relative volatility than at-the-money puts. This is because money managers and investors prefer to buy the less costly option as disaster protection. A $2 put is still cheaper than a $5 put even though the volatility might be significantly higher. So how does a trader best utilize volatility effects in his/her trading? First, it is important to know how a stock trades. Events such as earnings and news events may affect even similar stocks in different ways. This knowledge can then be used to determine how the options might behave during certain times. Looking at volatility graphs is a good way to get a feel for where the volatility normally trades and the high and low ends of the range. A sound strategy and calculated methodology are critical to an option traders success. Why is the trade being implemented? Are volatilities low and do they look like they could rally? Remember that implied volatility is the markets perception of the future variance of the underlying asset. Low volatility could mean a very flat market for the foreseeable future. If a pricing model is being used to generate theoretical values, do the market volatilities look too high or low? If so, be sure all the inputs are correct. The market represents the collective intelligence of the option players universe. Be careful betting against smart money. Watch the order flow if possible to see who is buying and selling against the market makers. Check open interest to get some indication of the potential action, especially if the market moves significantly. By keeping these things in mind and managing risk closely, you will increase your odds of trading success dramatically. RELATIONSHIP BETWEEN VOLATILITY AND DELTA One of the concepts that seems to confuse new options traders is the relationship between volatility and delta. First, lets quickly review each topic separately. Volatility represents the level of uncertainty in the market and the degree to which the prices of the underlying are expected to change over time. When there is more uncertainty or fear, people will pay more for options as a risk control instrument. So when the markets churn, investors get fearful and bid up the prices of options. As people feel more secure in the future, they will sell their options, causing the implied volatility to drop. Delta can be thought of as the sensitivity of an option to movement in the underlying asset. For example, an option with a delta of 50 means that for every $1 move in the underlying stock the option will move $0.50. Options that are more in-the-money have higher deltas, as they tend to move in a closer magnitude with the stock. Delta can also be thought of as the probability of an option finishing in-the-money at expiration. An option with a delta of 25 has a 25 percent chance of finishing in-themoney at expiration. An increase in volatility causes all option deltas to move toward 50. So for in-the-money options, the delta will decrease; and for out-of-themoney options, the delta will increase. This makes intuitive sense, for when uncertainty increases it becomes less clear where the underlying might end up at expiration. Since delta can also be defined as the probability of an option finishing in-the-money at expiration, as uncertainty increases, all probabilities or deltas should move toward 50-50. For example, an in-the-money call with a delta of 80 under normal volatility conditions might drop to 65 under a higher-volatility environment, reflecting less certainty that the call will finish in-the-money. Thus, by expiration, volatility is zero since we certainly know where the underlying will finish. At zero volatility, all deltas are either 0 or 1, finishing either out-of-themoney or in-the-money. Any increase in volatility causes probabilities to move away from 0 and 1, reflecting a higher level of uncertainty. It is always important to track volatility, not only for at-the-money options but also for the wings (out-of-the-money) options as well. A trade may have a particular set of characteristics at one volatility level but a completely different set at another. A position may look long during a rally but once volatility is reset, it may be flat or even short. Knowing how deltas behave due to changes in volatility and movement in the underlying is essential for profitable options trading. APPROPRIATE TIME FRAME The next step is to select the appropriate time frame for the kind of trade you want to place. Since I am no longer a day trader, Im usually in the 30to 90-day range of trading. And for the most part, I prefer 90 days. Since I dont want to sit in front of a computer all day long at this point in my trading career, I prefer to use delta neutral strategies. They allow me to create trades with any kind of time frame I choose. Delta neutral strategies are simply not suitable for day trading. In fact, day trading doesnt work in the long run unless you have the time and the inclination to sit in front of a computer all day long. Day trading takes a specific kind of trader with a certain kind of personality to make it work. My trading strategies are geared for a longer-term approach. If youre going to go into any business, you have to size up the competition. In my style of longer-term trading, my competition is the floor trader who makes money on a tick-by-tick basis. But I choose not to play that game. Ive taken the time frame of a floor traderwhich is tick-bytickand expanded it to a period floor traders usually dont monitor. Applying my strategies in longer time frames than day-to-day trading is my way of creating a traders competitive edge. CONCLUSION Delta neutral trading combines options with stocks (or futures) and options with options to create trades with an overall position delta of zero. To set up a balanced delta neutral trade, it is essential to become familiar with the delta values of ATM, ITM, and OTM options. Deltas provide a scientific formula for setting up trading strategies that give you a competitive edge over directional traders. Experience will teach you how to use this approach to take advantage of various market opportunities while managing the overall risk of the trade efficiently. I cannot stress enough the importance of developing a working knowledge of the deltas of options. Professional options traders think in terms of spreads and they hedge themselves to stay neutral on market direction. The direction of the underlying stock is less important to them than the volatility of the options (implied volatility) and the volatility of the underlying stock (statistical or historical volatility). Professional options traders also let the market tell them what to do. They recognize the market is saying that the appropriate strategy is to sell premium when option volatility is high (options are expensive). Conversely, they understand the market is saying that the low-risk strategy is to buy premium when implied volatility is low (options are cheap). The most difficult aspect of delta neutral options trading is learning to stay focused on volatility. The reason its psychologically hard to trade on volatility considerations is because its natural to look at a price chart, draw conclusions about future market direction, and be tempted to bias your positions in the direction you feel prices will move. However, the point of delta neutral trading is that you want to make money based on how accurately you forecast volatility; you dont want to run the risk of losing money by forecasting market direction incorrectly. Thats why you should initiate your spreads delta neutral. Its also why you should adjust them back to neutral if they later become too long or short which brings us to the second most difficult aspect of delta neutral options trading: acting without hesitation when the market tells you to act. If your position becomes too long or short, you must mechanically adjust it without hoping for the price to move in the direction of your delta bias. While its natural to want to give the market a chance to go your way, the fact of the matter is that the market has already proven you wrong, so it would only be wishful thinking to expect it will suddenly move the way you want. Every delta neutral trader knows the feeling of having a weight lifted from his shoulders the moment he or she does the right thing by executing an adjustment to get neutral. When you buy premium, be prepared to take action if the market makes a big move so you can lock in profits. When you sell premium, dont expect volatility to collapse right away. You will probably need to be patient. You hope the underlying asset wont move a lot while youre waiting. However, time decay helps you while youre waiting. As you can see, the concept of delta neutral is not one trade, but rather a method of advanced thinking. If you can master the basics of delta neutral thinking, then you can create delta neutral trades from any combination of assets. The concept is to be able to make a profit regardless of where the stock moves. |
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