Derivatives

All you wanted to know about the key properties of volatility

Venkatesh Bangaruswamy | Updated on June 26, 2021

Do remember that any rise in volatility will increase the value of both calls and puts

Last week, we discussed how to “fix” at-the-money options. This week, we look at the characteristics of volatility and why ATM options can be used to take advantage of your view on volatility.

Observed properties

Volatility is the fluctuation in the underlying price over a specified period. Empirical research suggests that volatility exhibits certain properties that are important for an option trader:

One, volatility is inversely related to the market movement. This is evident from the volatility index or VIX. When the Nifty Index is up, the India VIX is typically down. This is because fear is more powerful than greed. Therefore, volatility is greater when the market declines than when the market is up.

Two, volatility typically comes back to some average level (mean-reverts). So, if the current level of volatility is higher than in its average level, then the volatility will decline in the future. Likewise, if the current level of volatility is lower than its average level, then the volatility will increase in the future.

Three, volatility typically increases at a faster rate when the market declines and decreases at a slower rate when the market moves up.

Finally, volatility clusters. That is, if today’s volatility is higher, then tomorrow’s volatility is likely to be higher as well as the day after and so forth, till volatility suddenly declines. And then, subsequent days will continue to have lower volatility.

So, how do these observations help in trading options? An important factor driving option value is volatility. An increase in volatility will increase the value of both a call and a put. Likewise, a decrease in volatility will reduce the value of both a call and a put. Therefore, it is useful to bet on volatility applying its observed characteristics.

The issue is that the valuation model assumes that today’s volatility is independent of yesterday’s volatility, which is not true. Therefore, standard deviation, used as a measure of volatility, is inaccurate. So, option traders do not determine volatility. Instead, they infer volatility (implied volatility) from the option price. You can determine implied volatility for each strike by plugging-in the current spot price, the strike price, the time to maturity and the risk-free rate along with the current option price into an option valuation calculator.

You should observe over certain time the change in the implied volatility of the ATM option on the underlying on which you want to trade options. That will help you take a view on whether implied volatility is likely to increase or decrease in the future.

You can adjust your strategies to take advantage of view on volatility. How? ATM options are the most sensitive to change in volatility. Suppose you have a view that the underlying is likely to move up and that the implied volatility will also increase. You can buy the ATM call and short a strike that is above the price where the underlying is expected to face resistance. If your view is correct, the long call will increase in price not only because the underlying has moved up but also because the volatility has increased.

Optional reading

Time value of an option has two components: time to maturity and implied volatility. The time to maturity decreases with each passing day. However, implied volatility can increase or decrease depending on the actual demand for a strike. So, even if the underlying is moving up, decrease in demand for a particular strike will lead to a decline in implied volatility.

A decline in implied volatility combined with the passage of time will accelerate time decay or theta. This acceleration is the highest for ATM option as it has the highest vega, the highest gamma and, therefore, the highest theta. This is a primary reason option traders prefer ATM options when they want to take short positions closer to expiry.

The author offers training programmes for individuals to manage their personal investments

Published on June 26, 2021

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