Derivatives

Are you long or short on volatility?

Venkatesh Bangaruswamy | Updated on July 03, 2021

Volatility is the most important of 5 factors that decide option price

Last week, we discussed the observed properties of volatility. Responding to that article, a reader posed this question: Is a long position in a call option also long on volatility? Understanding whether you have a long or short position on volatility is useful for trading options. Therefore, this week, we discuss why a long position in option does not always mean a long position in volatility.

Long option, short volatility

An option is priced based on five factors, the most important of which is volatility. One observed property of volatility we discussed last week was that volatility is inversely related to market movement. That is, when broad market climbs up, volatility typically declines. And when broad market declines, volatility typically increases.

Note that we refer to a position as long if it gains when the underlying moves up. Logically then, a position is short if it gains when the underlying declines. For instance, if you are long on July Nifty futures, you gain if the underlying moves up. And if you are short on the July Nifty futures, you gain if the underlying declines. Extending this argument, if you are long on volatility, you should gain when volatility increases or explodes, which happens when the market declines sharply.

This leads to the observation that a long position in an option does not necessary mean you are long on volatility. Why? Consider a near-month deep in-the-money (ITM) Nifty call. This option will have high intrinsic value and will move very closely with the spot index. When the underlying declines sharply and volatility increases, this deep ITM option will lose value. Why? The price of a call option moves in the same direction as the underlying. So, the near-month index call will lose value when the index declines. True, an increase in volatility should make options more valuable. But the positive impact of volatility on the option price is less compared to the loss in value because of the decline in the underlying.

Now, we can put these two arguments together. Argument 1: Volatility increases when market declines. Argument 2: You are short on volatility if your position loses money when volatility increases. Therefore, you can conclude that a long position in a deep ITM index call is short on volatility. That is, returns on the option is negatively correlated to volatility. This argument is not true for at-the-money (ATM) options; long position in near-month ATM options can be long on volatility.

Optional reading

Two factors work on the deep ITM index call. One, the sensitivity of the option to the change in the underlying price, captured by the option Greek, delta. For instance, if the option has a delta of 0.86, it means that the price of the call will increase by 0.86 point for every point move in the underlying. And two, the sensitivity of the option to the change in underlying volatility, captured by vega. If the vega of an option is, say, 2.5, then it means that the option price will change by 2.5 points for every one percentage point change in implied volatility, if all other factors do not change.

So, when the underlying declines, the deep ITM index call will lose value because of its delta- 0.86 points for every point decline in the index. On the other hand, an increase in volatility will increase the option price through its vega. But the loss in option price through its delta is much more than the gain in option price through its vega. Why? The magnitude of change in the underlying is typically greater than that of the change in volatility. Also, vega of an ITM is small compared to the vega of an ATM option. Therefore, a deep ITM index call will lose value when volatility explodes, which happens when the underlying declines sharply.

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

Published on July 03, 2021

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