Taking Advantage of Higher Volatility When Trading Options
When the time value of an option is increased, this will invariably lead to an increase in premium, but can only occur due to the effect of either an increase in the variables of days to expiry, or an increase in that of volatility. The effects of an increase in volatility are more clearly visible when regard is had to the dramatic differences in consequence that both of the above scenarios exhibit. When an increase in days to expiry is responsible for an increase in premium, time decay can be quantified with respect to a fixed number of days. In the case of an increase in price due to rising volatility, in addition to the time decay that would ordinarily be attributed to the option, the increase reflected in the price will also need to be defrayed over that amount of time remaining in that options life. It is for this very reason that time decay increases when volatility increases.
The validity of these propositions are put to the test when a move in the underlying instrument, is compared with time decay. For the seller of options, it is hoped that the latter will prevail against the former. This compromise between interim loss and interim gain is the centre piece of an intriguing and profitable strategy.
An option model makes a numerous assumptions, the most outrageous of which is that all the variables will remain constant till expiry. This necessarily includes volatility, and the assertion that volatility is continually susceptible to change is unlikely to be challenged.
Implied volatility may rise for a number of reasons, not the least of which is the movement of the underlying at that particular point in time however; this does in no way commit the market to replicate that behavior continually until expiry.
In this regard, it is possible to capture enormous theoretical edge when volatility rises, by selling options not only to accrue a higher rate of time decay, but also to capture mathematical value. The strength of this strategy lies in the correlation between the inanimate pricing model and the emotive underlying market. Markets are over bought and oversold every day; indeed the premise that the majority of orders in a market are stop loss orders, suggests that this is precisely where market volume derives its rhythmic existence.
Indeed, if a seller of options enjoys a theoretical edge in their favour each time they sell, any one particular trade may not present a profit, but there is no doubt that a series of theoretical edges will result in sustained profitability. Certainly, reality may outperform theories and texts, and for a time put them to scrutiny however, when reasonably adapted to a dynamic marketplace, a quantitative benchmark is able to bring objectivity and discipline to the fore. Armed with probability analysis and a sensibly adjusted model, the only issue to be yet resolved is the inherent arbitrariness of the term ‘high volatility’. This term of course, like many curiosities is relative to its user. What is high volatility in one economic climate will not be so in another, and it is with just such cooperation with external forces that the rigidity of the mathematical model needs to be tempered.
The validity of these propositions are put to the test when a move in the underlying instrument, is compared with time decay. For the seller of options, it is hoped that the latter will prevail against the former. This compromise between interim loss and interim gain is the centre piece of an intriguing and profitable strategy.
An option model makes a numerous assumptions, the most outrageous of which is that all the variables will remain constant till expiry. This necessarily includes volatility, and the assertion that volatility is continually susceptible to change is unlikely to be challenged.
Implied volatility may rise for a number of reasons, not the least of which is the movement of the underlying at that particular point in time however; this does in no way commit the market to replicate that behavior continually until expiry.
In this regard, it is possible to capture enormous theoretical edge when volatility rises, by selling options not only to accrue a higher rate of time decay, but also to capture mathematical value. The strength of this strategy lies in the correlation between the inanimate pricing model and the emotive underlying market. Markets are over bought and oversold every day; indeed the premise that the majority of orders in a market are stop loss orders, suggests that this is precisely where market volume derives its rhythmic existence.
Indeed, if a seller of options enjoys a theoretical edge in their favour each time they sell, any one particular trade may not present a profit, but there is no doubt that a series of theoretical edges will result in sustained profitability. Certainly, reality may outperform theories and texts, and for a time put them to scrutiny however, when reasonably adapted to a dynamic marketplace, a quantitative benchmark is able to bring objectivity and discipline to the fore. Armed with probability analysis and a sensibly adjusted model, the only issue to be yet resolved is the inherent arbitrariness of the term ‘high volatility’. This term of course, like many curiosities is relative to its user. What is high volatility in one economic climate will not be so in another, and it is with just such cooperation with external forces that the rigidity of the mathematical model needs to be tempered.
Posted by The Options Hunter Blog at 4/23/2010 2:11 PM 
Categories: options volatility
Tags: volatility options
Categories: options volatility
Tags: volatility options
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