Derivatives

Time spreads to bet on volatility

Venkatesh Bangaruswamy | Updated on July 10, 2021

Retail investors should set up near-pure volatility strategies

Last week, we discussed why a long position in a call option is not necessarily long on volatility. This week, we discuss a strategy that you can setup to take a bet on volatility.

Volatility bet

Betting on volatility is predominantly the domain of institutional investors for several reasons. One, pure volatility products such as volatility swaps and variance swaps are over-the-counter offerings that are not available for retail investors. Two, most of these products require large capital outlay. And three, the products can be complex to understand.

Retail investors should, therefore, set up near-pure volatility strategies with exchange-traded options. We mention “near-pure” volatility strategies because options are driven by other factors that cannot be easily neutralized to offer pure volatility exposure. For instance, an option price will also be affected by the upward or the downward movement in the underlying, captured by the option’s delta.

You can set up a near-pure volatility trade with a time spread. This requires setting up a long and a short position in a same strike (preferably, ATM) option with different expiry dates. For instance, you can buy the next-week Nifty 15800 call and short the near-week Nifty 15800 call. This is a net debit spread because the next-week option, with a greater time value, will have a greater price. Applying the convention, a net debit spread is a long time spread. Conversely, shorting the next-week 15800 call and going long the near-week 15800 call will result in a net credit and is, therefore, a short time spread.

If you expect implied volatility to increase, you should set up a long time spread. And if you expect implied volatility to decline, you can setup a short time spread. Why?

Vega captures the sensitivity of an option to change in implied volatility. Now, longer the maturity, greater the vega of an option. So, the next-week 15800 call will have a greater vega (10.23) than the near-week 15800 call (5.56). If implied volatility jumps as expected, the next-week call will increase more than the near-week call. So, the long time-spread will be profitable. Conversely, if implied volatility declines, the next-week option will decline more than the near-week option. So, the short time-spread will be profitable.

You are setting up a volatility trade to bet on an increase or decrease in implied volatility, without preferably having the directional risk of the underlying. This means you want the option position to be delta-neutral. That is, the delta of the long call should be equal to the delta of the short call. The net delta of the long 15800 call time spread is nearly zero (0.59 for the near-week Vs 0.58 for the next-week)

The delta of the position will also change as the underlying changes. This is captured by gamma, the rate of change in the delta. To ensure that your position continues to have zero or near-zero directional risk, you have to adjust the position’s delta frequently. But that would be expensive.

Optional reading

Long options have positive vega and short options have negative vega. This is true for both calls and puts. So, you should set up positions with positive vega if you expect implied volatility to jump and setup positions with negative vega if you expect implied volatility to decline.

What happens to the time spread if the underlying makes large upward movement? Both options will increase by the same magnitude in relation to its intrinsic value. That is, if the underlying moves from 15800 to 15900, the intrinsic value of both the near-week and the next-week options will increase by 100 points. The time value is typically small for in-the-money and deep out-of-the-money options. Therefore, the price difference between the two options in the time spread will narrow as both become ITM. Note that both options will expire worthless if the underlying declines below the strike.

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

Published on July 10, 2021

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