So You Want to Trade Options — Volatility Trading 101

Volatility is the price of an option

When we price an option we will use, in most cases, the Black-Scholes option pricing model. While there are few underlying flaws in the assumptions of the model (you can check out my blog post about volatility model for more), this model serves us well as an accounting standard (meaning that it produces are robust price given our parameter). To be able to price an option (any option), we need to provide the following parameter:

  • Strike price
  • Time to expiry
  • Option type (Call/Put)
  • Risk-free rate and dividend yield/Domestic rate/Cost-of-carry
  • Volatility

A quick and dirty option pricing

After we established that our primary motivation in options trading is trading volatility we want to put that into use and see how volatility translates into the price of an option and how we can turn that into a trading strategy.

Talking Greeks

Now that we know how to price options (kind of), how to approximate our ATM straddle breakeven (roughly), and how volatility and time affect our option price, let’s understand how each parameter affects our option price. The easiest way to test our option sensitivity to the underlying parameters is to use nonparametric approximation (remember there are 4 changing variables in the B&S formula: Spot, Rates, Time, Volatility). While this might sound intimidating, it’s simply shifting the different parameters up/down and test the option’s sensitivity to each underlying parameter separately.

  1. Vega(ν) — The sensitivity of the option price to the change of implied volatility.
  2. Theta( Θ) — The sensitivity of the option price to the passage of time (aka, “time decay”)

The Volatility-Gamma-Theta Triangle

By now we’ve come a long way from an introduction to options (and options trading) to understand that we trade volatility and the different derivatives.

Volatility and Dynamic Hedging

Now that we know how to price options, Greeks, and the magical triangle of Volatility-Gamma-Theta, we can move on to the real fun part of options — Volatility Trading. As we trade volatility we should maintain our options portfolio delta-neutral (or in other words, indifferent of the market direction), that means we don’t care whether the market goes up or down, as long as our view on volatility is correct (either volatility will realize above the implied volatility we bought, or below the implied volatility we sold). The way we “realize” volatility is by using “Dynamic Hedging”. This supercool term is essentially just buying/selling the underlying asset (based on our option’s delta to maintain the portfolio delta-neutral).

Final Thoughts

Although I tried making this write-up an introduction to option (volatility) trading, I barely scratched the surface of the world of options and volatility. That reminds me of the early stage of my boxing experience. When I started boxing my coach told me: “You can’t learn boxing from online videos and tutorials. Nothing beats the actual experience inside the ring when you face danger”. This resembles trading a lot, as any book (no matter how good it is), cannot teach you how to manage and run the day-to-day risk of option trading volatility. Options trading is a journey that can take many shapes and forms. It depends on our scope of interest, ability to learn new concepts, and adapts to everchanging markets.

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