Trading options without understanding how volatility impacts them can mean you're trading treacherously.
As discussed in a previous Trader's Corner article, one of the components of options pricing is called vega. Vega measures the change in an option's price for each percentage change in volatility. An increase in volatility plumps up an option's price if all other factors remain the same, and a decrease in volatility decreases it.
The volatility we're talking about isn't the VIX or the VXN or the RVX or any of the other volatility measures of the major indices. It's the implied volatility of the option itself. Consider a stock such as H.J. Heinz Stores (HNZ). The VIX can remain the same and the price of HNZ can remain the same, but if there is a change in the expected volatility of HNZ, the implied volatility of its options might change, too, no matter how stable its stock price might be. This effect is sometimes magnified around earnings reports. Investors might be buying puts on a stock, for example, to protect against any downside risk while a stock's price stays rather steady, with investors waiting to see the report before either buying or selling more stock. The price of those sought-after puts goes up and so does their implied volatility.
But what happens if investors react with boredom to an earnings announcement after the implied volatility of the options has been plumped up? Likely that implied volatility will sink again and so will the prices of the options. That would be true if the underlying's price stays about the same or even if it sinks, but sinks only slightly and slowly.
Using an options price calculator can show you the effect of a lower implied volatility on an option's price. You can find a free calculator at iVolatility. The sidebar on the left side of the page includes the heading "Basic Calculator," and that's where you'll find the free calculator after a couple of click-through's. Many brokerages also provide a calculator as well as information about historical and implied volatility. This article will employ BrokersXpress's option pricer.
Let's use HNZ to look at some the effects that occur with changing volatility, starting with a daily chart. Remember when viewing this material that this article was prepared early and the prices do not reflect current prices.
Daily Chart of HNZ:
On November 18, only three days before option expiration, a November 40 call sported an implied volatility of 84.18. A December 40 call had an implied volatility of only 57.70 and the January one, an even lower volatility. Volatility was clearly higher into the earnings and option's expiration.
What if HNZ had decided to announce early, the morning of November 19, for example? (This hypothetical situation of course did not occur, and HNZ reported at its expected time, but this hypothetical situation is meant to demonstrate the effect of a sudden change in volatility on options prices.) Imagine that once the news was known in this hypothetical situation, the implied volatility in the November option sank to 60.00, closer to the implied volatility in the December options. At the close on November 18, the option pricer returned a value of $1.946 for the HNZ November 40 call with a volatility of 84.18, but suggested a price of only $1.503 the next morning if the volatility sank to 60 in that hypothetical early announcement scenario. Almost $0.20 of the change was due to the passage of another day but the other $0.243 decrease was due to the lower implied volatility.
Changes in volatility can impact combination trades, too. For example, calendars are trades in which a shorter-term option is sold and a longer-term option at the same strike is bought as a hedge. For example, if a calendar in GLD was initiated, a DEC GLD 73 call might be sold and a JAN GLD 73 call bought as a hedge, for example. The long January call is more expensive than the December one, an intuitive result. That means that the more expensive January call has more extrinsic value that can be impacted by a change in volatility. Extrinsic value is the value above the in-the-money value.
On November 18, the midpoint between the bid and the ask for such a calendar was $1.20, so that value was input into a profit/loss chart. The chart is shown below.
Profit/Loss Chart for GLD 73 Strike Calendar:
The trade calculator showed breakevens at $66.98 and $80.23. What happens, however, if volatility decreases over a two-week period? The green line on the chart below represents the graph for the hypothetical new situation as of December 2, 2008 with an approximate 30 percent decrease in implied volatility.
Profit/Loss Chart for GLD 73 Strike Calendar with Decreased Implied Volatility:
The chart may be somewhat difficult to decipher due to sizing requirements, but the $0.00 benchmark that differentiates a profitable trade from a losing one is about midway up the vertical axis, above the green line. This means that there is no price point at which this hypothetical trade would be profitable two weeks after being instituted if volatility had dropped about 30 percent. Moreover, the breakevens at expiration, represented by the blue line, had narrowed from the previous $66.98 and $80.23 to $70.65 and $75.59. The trader had much less room for a profitable trade.
If volatility had increased, the opposite effect would have been seen.
Profit/Loss Chart for GLD 73 Strike Calendar with Increased Implied Volatility:
Again, the sizing requirements make it difficult to see the $0.00 benchmark, but this time the green line is above that benchmark from about $61.50 to $87.80. Two weeks from the initiation of the hypothetical calendar trade, the increased volatility would have allowed this calendar to be profitable if GLD were between those levels. Moreover, breakevens at the December option expiration would have widened to $63.98 and $84.31.
This single article could not address all the ways that volatility impacts options trades. Its purpose was to present the idea that an option trade is not all about what happens to the price of the underlying. Changes in implied volatility can help or hurt your options trades. Trades such as purchasing an option or calendars benefit from an increase in implied volatility. For these types of trades, a trader would want to purchase low-cost options with low implied volatilities compared to historical levels. Most brokerages provide volatility charts that show this information. If the implied volatility is not low with respect to historical norms, the trader might believe that implied volatility was going to stay steady or increase.
Other types of trades such as condors or just selling an option benefit from decreases in implied volatilities. Traders should choose options with higher-than-normal implied volatilities that the trader believes will decrease over the course of the trade.
Most of all, traders should acquaint themselves with the types of trades that benefit from increased or decreased volatilities. A good place to start would be Chapter 37, "How Volatility Affects Popular Strategies" in Lawrence C. McMillan's Options as a Strategic Investment. Those who prefer their information free, via a webinar, can click on the "Strategy" tab on the CBOE's website where a link to the CBOE's Strategy and Education Videos can be found. Those by Dan Sheridan always discuss volatility issues and Brian Overby's sometimes do, too. A search of Amazon turned up books such as Dan Passarelli's Trading Option Greeks: How Time, Volatility, and Other Pricing Factors Drive Profit among others.