Ways to Use Option Volatility

By: David L. Caplan

The following is an excerpt from Dave Caplan's The Option Secret

The most overlooked and underutilized factor by most option traders is the significance of volatility. This includes both the effect of volatility on the premium cost of the option when purchased and of future changes in volatility on the position.

Volatility is simply a mathematical computation of the magnitude of movement in an option. This is based on the activity in the underlying market. If the market is making a rapid move up or down, volatility will rise; in a quiet market, volatility will be low.

When volatility is relatively low, you should look for option buying strategies as the market is quite likely to make a strong move; and, when option premium is high, option selling strategies should be considered to take advantage of the relatively over-valued premiums.

Volatility is an important factor in determining the price of an option because all option models depend heavily on the calculation of volatility in determining the "fair market value" of an option. What we are actually saying when we calculate volatility is that the odds are 67% or better that the market will hold within the calculated range over a period of one year.

For example, if gold is trading $500 per ounce and had a volatility of 20%, the probability is that gold will hold a range of $400 to $600 (20% on either side of $500) for a one year period. Based on this, option sellers can calculate the premium they would want to receive for selling various gold puts and calls based on the probability that the strike price would be reached prior to the expiration of the option. If the volatility is high, option sellers would determine that it is more likely that the option price could be reached and ask a higher premium; if volatility is low the option seller would determine that it is unlikely that the option would be exercised and therefore ask less for selling that option.

There are two types of volatility – historical and implied. Historical volatility is calculated by averaging a past series of prices of options. For example, a trader could use a 90-day price history, a 30-day price history, a 10-day price history, etc… to determine the options "historical volatility." Obviously, each set of calculations result in a different figure for volatility and produce different theoretical (fair value) for the options.

Implied volatility is calculated by using the most current option prices, commodity price level, time to expiration, and interest rate. This method provides a more accurate picture of the current volatility of an option, compared to the historical volatility, which is a smoothing of past price action. I use "implied volatility" in my option pricing calculations, and then compare the current numbers to past records of implied volatility to determine whether volatility is relatively high or low.

Another overlooked area is the difference in volatility between different months and strike prices of options. When I calculate volatility, I always use strike prices that are nearest to the money, as I feel that this is the most accurate representation of the actual volatility of the option contract. Many times, premiums of out-of-the-money options can be distorted greatly.

For example, in June 1987, silver ratio spreads provided a high probability of profit, because the volatility for the out-of-the-money silver calls were double the volatility of the at-the-money calls. This can lead to significant opportunities. When options approach expiration, volatility for all of the strike prices will tend to equalize. In this instance I purchased the most fairly priced call (near-the-money), and sold the most overvalued calls (out-of-the-money). I could expect the options sold to lose premium faster as the market moved in either direction. Even if the market were to move higher (unless making a straight up vertical move) this spread would have also worked as the nearer-to-the-money option would have gained value faster than the already overpriced out-of-the-money options.

Another overlooked characteristic of volatility is that option volatility tends to drop gradually then level off. However, at times volatility increases can be characterized by very sharp changes in volatility driving option premium to extremely high levels. These events occur rarely, but when they do they can be very damaging to those holding short option positions. An example was when the volatility increased in many markets at the beginning of the Gulf War. Oil volatility doubled, while other markets such as gold, bonds, and currencies increased 20% or more. Even seemingly unrelated markets such as cattle increased dramatically.

There are also intraday fluctuations in volatility and premium. Since implied volatility is based on the closing price of the option, many times intraday fluctuations in prices will create option volatility that is much higher than the volatility based on the closing price. These types of fluctuations seem to always be of the higher nature. Rarely does option volatility drop any significant degree during a trading day. Taking advantage of these intraday price swings and distortions in option valuation can provide a trader with significant trading opportunities.

Changes in volatility affect the premium levels in options you are going to purchase, as well as those you have already purchased or sold. A good example of this is in the crude oil and the S&P 500 option market where volatility has ranged between 20% to over 100%. With high volatility, if we were to purchase an out-of-the-money option, you would need a substantial price rise before that option would be profitable at expiration. Both the expense of the purchase price of the option and time value would be working severely against you. However, with volatility at lower levels, this option would not only cost much less but would require a smaller move for the position to be profitable. This is because many times as prices begin to rise, volatility also increases, thereby increasing the premium of the option purchased.

The concepts of option volatility, along with the time decay characteristic of options, are the two most important and most overlooked factors in option trading. These concepts can be difficult to learn and use, but the proper use of these option characteristics can result in a "trading-edge" over the markets.