Mastering Derivatives: How to combine volatility bets with directional view

You typically set up a bull call spread when you have a positive view on the underlying. But can you combine your directional view with a view on volatility? This week, we discuss the difference in trade set-ups between European and American options when you combine your view on the underlying with that on volatility.

Vega capture

When you have a view on volatility, you are taking a bet that implied volatility is likely to explode (increase) or implode (decrease). Suppose the implied volatility of an underlying has been 20 per cent in the recent past and the current implied volatility is 12 per cent. Further, suppose an event is likely to happen in the future whose outcome is unknown. You expect the implied volatility to explode during this period. You also have a view that the underlying is likely to move up and face resistance at a higher price. What should you do?

You could set up a bull call spread where the lower strike call is either an at-the-money (ATM) or an immediate out-of-the-money (OTM) call. Your choice of the strike will be based on the liquidity rule; choosing a strike that has the highest change in open interest. The short call will be a strike immediately above the resistance level for the underlying. But when you have a view on volatility, your set-up ought to be aligned to capture gains from vega.

The sensitivity of an option price to change in volatility is captured by the option Greek vega. An ATM option has the highest vega. This means that the price of an ATM option will change the most for a one percentage point change in volatility. Also, an option price rises when volatility explodes, and an option price falls when volatility implodes. Combining these two arguments, you should consider going long on an ATM option when you expect volatility to explode and consider shorting an ATM option when you expect volatility to implode.

Now, consider the first scenario — underlying moving up and volatility exploding. If you go long on an ATM option, you could short an OTM option that is one strike above the resistance level. So, this strategy is the same as the regular bull call spread when you do not have an explicit view on volatility.

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Consider the second scenario — underlying moving up and volatility imploding. Now, you must short the ATM option. In a bull call spread, the short strike is the higher strike. Therefore, the lower strike must be an in-the-money (ITM) call. But this poses a problem. The maximum gain in a bull call spread is the difference between the strikes less the net debit. Therefore, the position — long ITM call and short ATM call — will not allow you to capture maximum potential gains, as the resistance level for the underlying will be above the ATM strike.

Also, ITM strikes are not liquid for European options. Therefore, you are forced to choose between ATM and OTM strikes. Your optimal strategy for the second scenario would be: long immediate OTM strike and short one strike above the resistance level, which is not different from a regular bull call spread.

Optional reading

If you were to trade American options, you could buy a deep ITM call for the second scenario discussed above. Even if the strike were not traded, you can exercise the option when the underlying reaches your price target before expiry. Note that you can capture only the intrinsic value when you exercise an option. Also, when volatility implodes, the time value of an ATM option will decline more than that of an ITM option.

The upshot? Combining your direction view on an underlying with a volatility bet places ATM option at the centre. But adjusting a bull call spread for a volatility implosion could be an issue for European options.

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

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