Trading Option Volatility – Part Two
A rule often echoed in volatility trading circles is that an option is only ever worth what someone will pay for it, or conversely what someone will sell it for. Primarily this is due to the fact that price is invariably indictated by supply and demand however there is a broader manifestation that has always been apparent, but that is only now evident after the 2008 global financial crisis and the redundancy it affected upon Efficient Markets Theory.
Certainly, an option trader will most likely need to close out their position at some point, particularly if value is available for the privilege of doing so. The new paradigm that option traders have to work with however, encompasses the fact that regardless of where the rest of the market is pricing volatility, taking a volatility position and maintaining it will (apart from margin requirements) remain quite independent from the rest of the market. It is not uncommon for implied volatility to be trading at 12% when historical volatility is actually 6%. Indeed, in the 1980’s and early 1990’s, option markets were in their infancy and traded at premiums that were nothing short of arbitrary volatility inputs into a model. When the astute realized the discrepancy between theory and reality, volatility hammers were deployed into service across the globe.
Of course the same can occur when markets are inherently more volatile than implied volatility may suggest. A poignant example of this is the fact that most equity markets travel at a conservative 8%-11% historical volatility with the exception of a handful of trading days throughout the year when volatility will breach all containment lines and register at the 35%-40% mark. It is for these reasons that traders need to bear in mind that they are trading premium, and this is a daily compromise between time decay income or expense, and the re-hedging income or expense. The mathematical model however (invariably the Black-Scholes or a variation of it) will assume constant volatility from until the expiry of the contract. This is a clear limitation of the model which needs to be understood and catered for in the real world whose only constant is that of change. Of course, the volatility trader is able to reduce the risk of all these external forces by offsetting their position with other options. Due to the fact that they too labor under the same limitations, the risk of unforeseen eventualities hailing from outside the market place will be reduced.
Certainly, an option trader will most likely need to close out their position at some point, particularly if value is available for the privilege of doing so. The new paradigm that option traders have to work with however, encompasses the fact that regardless of where the rest of the market is pricing volatility, taking a volatility position and maintaining it will (apart from margin requirements) remain quite independent from the rest of the market. It is not uncommon for implied volatility to be trading at 12% when historical volatility is actually 6%. Indeed, in the 1980’s and early 1990’s, option markets were in their infancy and traded at premiums that were nothing short of arbitrary volatility inputs into a model. When the astute realized the discrepancy between theory and reality, volatility hammers were deployed into service across the globe.
Of course the same can occur when markets are inherently more volatile than implied volatility may suggest. A poignant example of this is the fact that most equity markets travel at a conservative 8%-11% historical volatility with the exception of a handful of trading days throughout the year when volatility will breach all containment lines and register at the 35%-40% mark. It is for these reasons that traders need to bear in mind that they are trading premium, and this is a daily compromise between time decay income or expense, and the re-hedging income or expense. The mathematical model however (invariably the Black-Scholes or a variation of it) will assume constant volatility from until the expiry of the contract. This is a clear limitation of the model which needs to be understood and catered for in the real world whose only constant is that of change. Of course, the volatility trader is able to reduce the risk of all these external forces by offsetting their position with other options. Due to the fact that they too labor under the same limitations, the risk of unforeseen eventualities hailing from outside the market place will be reduced.
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