Stock trading is easy to understand conceptually because it’s one-dimensional. Either the stock goes up, or it goes down. Clear and simple, at least from a trading and profit or loss perspective. Options trading, however, is multi-dimensional. Price, time, and volatility all impact the value and price of an options contract. On today’s show, we’re selectively choosing to highlight the impact that volatility has on options because, as we’ve seen in the 2020 market collapse, if you’re not managing volatility, it could become your worst nightmare.
This episode is the sister episode to OAP 135: You Don’t Need a Degree in Financial Engineering to Understand How Implied Volatility Works. In episode #135, we dove deep into where the implied volatility number comes from and how implied volatility is calculated. In this episode, we are going to discuss the impact of volatility on option pricing.
How Options Are Priced
- Options contracts are price based on two high-level categories: intrinsic value and extrinsic value.
- With call options, they have intrinsic value if the strike price is below where the stock is trading.
- Put options have intrinsic value if the strike price is above where the stock is trading.
- Out of the money contracts have no intrinsic value — there’s no value if you were to convert them from an options contract to a stock position.
- Extrinsic value encompasses time until expiration, implied volatility, and interest rates.
- As you get closer to expiration, all of the extrinsic value goes away until, at expiration, you’re left with just the intrinsic value of the contract.
What is Volatility?
- Volatility is nothing more than movement in the market.
- Volatility is non-directional — it can be movement in either direction.
- There are two classifications of volatility: expected and realized.
- The differential between the market’s expected movement and the actual realized movement creates implied volatility premium or the risk premium that’s embedded in option contracts.
- Broad, long-term trends show that markets move less than expected.
- The VIX is the graphic embodiment of volatility for the SPX or the S&P 500.
- The VIX is a 30-day representation of what volatility should be on the S&P or what people expect it to be.
- Volatility on the VIX and on the S&P is not the same as volatility on an individual security.
Why Does Volatility Change?
- Market forces are the driver of changes in volatility.
- Markets seek certainty. When you go into an uncertain environment, you start to see a rise in volatility or expected volatility.
- When you go from a known state to an unknown state very fast, that’s what causes such dramatic changes in volatility over a short period of time.
Impact of Volatility on Options Price
- The broad impact that volatility has on an option’s price is simply this: when implied volatility or expected volatility goes up, then option prices go up as well.
- Vega measures the impact of changes in implied volatility, or, more specifically, the price change in the option contract for every 1% change in implied volatility.
- When option prices change, they change differently based on how far you are from expiration.
- Vega values for option prices tend to be higher for further out contracts in time.
- For more on options Greeks, check out OAP: 44: Which Options Greeks Are the Most Important.
Example: SPY, 15 days from expiration
- The $250 at the money call options for April are trading for about $10.35.
- The Vega value is 21 — if volatility were to change by 1% for the S&P, then we should expect that the option contract, the call option at $250, to change by about $21. If volatility goes up by 2%, then we would expect that this option contract would go up by about $42.
- When looking at the May contracts, which are about 43 days to go until expiration, then the Vega value for the $250 calls is 34.
- As you go out further in time, small changes in implied volatility have a much greater impact as you go further out the expiration cycle.
- You would see a greater change in the options contracts value based purely on an implied volatility shift for the May contracts that are 43 days from expiration than you would for the April contracts, which are 15 days from expiration.
- The longer you are from expiration, then the greater the impact implied volatility will have on your option contracts price.
- Option contracts with strike prices closer to the current stock price have higher Vega values compared to option contracts of the same expiration that are further out of the money.
- When you go out to the 10 Delta call options for the April expiration, the $275 options, those have a Vega value of just 11.
- In the April expiration, Vega is going to have a greater impact on options contracts that have a strike price around $250 compared to option contracts that are at $275.
- When you go out to the 10 Delta call options in May, which are about the 280 strike, 43 days to go until expiration, the Vega value is 24.
Impact of Volatility By Strategy
- Undefined risk strategies as an option seller include: short put options, short call options, short strangles, and short straddles.
- These strategies see a dramatic change in the options price when volatility changes because these contracts are one-sided.
- Similarly, defined-risk, long option strategies are significantly impacted by changes in volatility. Examples as an option buyer include: buying a call, buying a put, buying a strangle, and buying a straddle.
- With undefined risk strategies or strategies where you’re a one-sided trader — pure selling, pure buying — those strategies are going to have the biggest changes in option price when volatility changes.
Defined Risk Strategies
- Defined risk strategies have somewhat offsetting moves from changes in volatility.
- Defined risk strategies include: credit spreads, debit spreads, iron condors, and iron butterflies.
- When you trade spreads, you have to think about the offsetting impact of volatility.
- When you trade a put option spread in the May expiration where SPY is trading at $250, and you sell the $240 put option and buy the $239 put option, you create a $1 wide credit spread.
- The Vega value for the $240 and the $239 put options are both the same at 33.
- Because the spread is so narrow, changes in volatility will be almost completely offset for that particular spread.
- If you sold the $240 put option and bought the $220 put option, now you’ve widened your defined risk spread to $20 wide.
- The $220 put option has a Vega value of 27, and the $240 put option has a Vega value of 33.
- When implied volatility drops, there will be a much bigger benefit to your position.
- If you sold a really wide iron condor and made the wings $20 from where the stock was trading and only did a $5-wide spread on either side, when implied volatility drops, you won’t get that big of an impact to our option price.
Understanding the impact of volatility on different strategies, like iron butterflies and iron condors, takes you to the next level in your option trading. This depth of understanding elevates you to a different level and allows you to be more effective in your strategy selection, less emotional, and a better decision-maker.
Option Trader Q&A w/ Ray
Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today’s question comes from Ray:
My question is focused on inverse ETF’s, like the SH from ProShares or TZA from Direxion. I think I understand the basic concept, but what confuses me is the notion of puts and calls in an inverse fund. If I buy a call in an inverse fund, does the call premium rise when the underlying goes down? Conversely, does the put fall? Why would I simply not buy a put in a traditional index fund if I am trying to hedge my account versus getting involved in an inverse fund? I’m sure I’m missing something here, but I would love to hear your input on that? Thanks.
Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.