Trading Option Volatility – Part One

Being a volatility trader is lucrative, but make no mistake, particularly in the post 2008 climate of heightened vigilance and regulation, the cost of funding positions will escalate. This is pertinent to volatility traders for the simple reason that they are required to hold open positions for an extended period of time. The beauty of volatility trading is found in the opportunities it provides. Options are a diverse animal, with inherent features that are complex and yet reliable.

From first principles, trading volatility is opposed to taking a directional view. Volatility is premium, and that is all that is of concern. To capture this premium in order to trade it, one must rely on mathematical models to provide a benchmark with which to be guided. It is worthy to note that this matrix of prices is merely a benchmark to shed light on the theoretical value of options given certain inputs such as strike, underlying price, type, days to expiry and notional volatility. As the fiasco of 2008 clearly indicates, theory is not reality. Real life will often outperform academia.

Apart from relying on the price output of the model, a trader will also be heavily reliant on the delta output, which represents the rate of change of an options price to that of the underlying. As a volatility trader, every option position needs to be hedged in order to capture the time premium of the option, and the delta will provide the trader therefore, with the precise ratio to apply in hedging the option position using the underlying instrument.

As the market moves upward and downward, the option’s price will change, but due to the fact that it has been hedged according to the precise delta output, the position will to some extent be protected; the time value has been captured. The fact of the matter is however, that the delta of an option is not static; it too changes as the market moves. The rate of change of the delta is the gamma, and will mean that when the market moves, the option position at some point will be found to have a different delta, and so the position is either over hedged or under hedged as the case may be. If the resultant tweaking of the hedge results in buying the underlying after a move upward, or selling the underlying after a move downward, this locking in of loss will be attributed purely to the short option position it supports. Even when a position is hedged, the seller of options bears unlimited risk. Of course when a profit is locked in each time the market moves upward and down, the security and benefits of a long option positions is enjoyed.

Again however, it must be noted that trading volatility is a daily trade-off between the competing income streams of time decay and hedging. While option buyers carry the risk of only a limited loss, there is certainly no joy to be found in a portfolio suffering an expensive  time decay bill each day, and the market stagnant with no opportunity to re-hedge.

 

What did you think of this article?




Trackbacks
  • No trackbacks exist for this entry.
Comments
  • No comments exist for this entry.
Leave a comment

Submitted comments will be subject to moderation before being displayed.

 Enter the above security code (required)

 Name

 Email (will not be published)

 Website

Your comment is 0 characters limited to 3000 characters.