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PTMC team 11.02 2015

The options in Protrader: volatility, direction, time

Hey there, Protraders!

As we already know, options – is the derivative financial instrument, the price formation of which is non-linear. In other words, not only the movement of the underlier affects the option cost. Option prices also depend on the implied volatility and time till expiration of the option. Using combining of the options, the trader can create the option strategy which more profitably will turn to advantage its current trading idea. For example, predicting the growth of the underlier, the mass of the option strategies can be used: buy Call option, sell Put option, buy bullish vertical or ratio spread, buy strangle with closest strike prices, sell strangle with distant strike prices, buy straddle and etc. All these strategies can bring profit with the growth of the underlier. But the growth can be different, this can be short-term, medium-term or long-term trend, herewith the asset volatility can grow, fall or remain unchanged. When trading with options, for each of the possible scenarios of the price movement there is the most suitable combination of options or strategy that allows extracting the maximum from the projected market situation. Every time, creating an option position, the trader expects to profit due to the influence of one or more factors of pricing. Simplistically, the option trading which is most oriented on one of the three main factors of the price formation can be divided into volatility trading, time trading and directional trading.

Volatility trading

What is the volatility? Two types of volatility exist. Historical volatility refers to the first type, which reflects volatility of the underlier prices and is usually a risk measure of investments. Usually, the historical volatility reduces to the annualized value.

Implied volatility refers to the second type. This indicator arises from the Black-Scholes model which describes price formation of the options and is generally accepted. In fact, implied volatility is an abstract concept. The physical meaning of this value is that the participants of option trading in a certain way predict the change in the volatility of the underlier over the lifecycle of the option. Making their trades, trading participants change the cost of the option under the law of supply/demand. Thus, participants of the option market implicitly include their forecast of asset volatility in the option prices. The volatility which can be obtained from option prices according to the Black-Scholes model is called an implied volatility.

The volatility is in the direct connection with option prices, the growth of volatility leads to the increase of option prices, the fall of volatility leads to the decrease of option prices. From the above it follows that for the successful trading we have no need to predict the direction of the underlier movement; it is enough to make an accurate prediction of the volatility. The whole class of option strategies that trade the volatility, rather than the price of the underlier, is based on this principle. Let’s consider a simple example, buy Put option with strike price 2000 on the March contract of index S&P mini. To do this, we will use the option module “Option master” of the Protrader terminal.

Put option with strike price 2000 on the March contract of index S&P mini.

Profile of the position will look like as follows:

Two additional curves are shown on the position profile, which reflect the theoretical option price with growth in volatility and with fall in volatility.

Two additional curves are shown on the position profile, which reflect the theoretical option price with growth in volatility on 20% (blue line) and with fall in volatility on 20% (green line). From the above chart it follows that growth of volatility on 20% raised the price of the observed option on 10 points, in its turn, the fall of volatility reduced the option price on 10 points. Accordingly, if the trader was able to predict the growth of volatility, he would have earned 10 points at a fixed price of the underlier. It can be concluded that the growth of volatility is favorable for long option positions, and a fall of volatility can bring a profit in the case of short option positions. When trading with volatility, symmetrical option constructions are often used, such as strangle, straddle, condor etc. Trading volatility, traders seek to minimize the impact of other price formation factors on the cost of options. Dynamic hedging of the option position is often used for levelling the impact of the underlier price change. Selection of the option contract that is optimal by the lifespan allows in some degree to reduce negative impact of time decay of option prices.

Predicting the change in volatility, the trader can receive profit even without changing the cost of the underlier. How do we determine the force of the volatility impact on option prices? The so-called greek “Vega” is responsible for the sensitivity of option prices to the changing in volatility. It shows how the option price will be changed when the volatility changes on 1%. Knowing the value of this coefficient for the selected option strategy, the trader can easily assess the possible fluctuations in the cost of the used options in a particular market situation.

Other things being equal, the options “at the money” are more sensitive to the changes in volatility than options far “out of the money” or “in the money”. This can be easily verified by plotting a curve of changing the “Vega” from the underlier price. For the selected Put option on the March contract of index S&P mini with strike price 2010, “Vega” possesses the maximum value when the futures price is around 2010 points. This suggests that the options “at the money” the most strongly react to changes in volatility, therefore, other things being equal; they are priority for volatility trading.

The options “at the money” the most strongly react to changes in volatility, therefore, other things being equal; they are priority for volatility trading.

Option trader has an access to at least 3 option contracts with different expiration dates for one underlier. Selection of an option contract for trading becomes quite a complicated task with the introduction of weekly options. Conformably to the volatility trading, it can be noted that, other things being equal, the options with long lifetimes are more sensitive to changes in volatility than options with shorter term to expiration. This fact should be considered when choosing an option contract when creating a position.

Directional trading

The second type of the option strategies is directional trading. As the name implies, this type of option strategies is based on the forecast of the underlier movement. Replacement of a long position by the underlier onto purchasing call options can be an example of such trading. Most traders, who have recently got acquainted with options, use exactly the directional strategies. In contrast to trading with the underlier, the change in cost of the option depends nonlinearly on the underlier movement. This means that reduction in the underlier price on 1$ while holding a long position by Call option, does not necessarily lead to the reduction in option price on 1$. Greek “Delta” is responsible for the sensitivity of option prices to the changes in the underlier price. “Delta” shows how the option price will be changed when the underlier price changes on 1 point. Thus, making an accurate forecast of the underlier movement, option trader can earn on “Delta”. “Delta” possesses its maximum values for options far “in the money”; in this case, one option contract behaves as 1 unit of the underlier.

"Delta" near options "at the money" has values of about 0.5 that corresponds to the position of 0.5 units of the underlier. Options far “out of the money” have minimal “Delta” and it approaches to 0 that indicates about a very weak influence of the underlier price on their cost. To illustrate this, let’s consider the chart of changing the “Delta” for long Put option on the March contract of index S&P mini with strike price 2010.

The chart of changing the “Delta” for long Put option on the March contract of index S&P mini with strike price 2010.

Why should we use options for directional trading if there is an underlier? Sometimes, the strategy of the directional trading on the underlier reproduced using options, has some advantages. For example, the reduction in the margin requirements, creation of the synthetic fixation levels of loss or profit with the probability to earn an additional income is also possible. In some situations, an option analogue of the position on the underlier has better profit/loss ratio.

There is a perception that “Delta”, among other things, reflects the probability of the option to be in the state of “in the money” before its expiration. Probability of achieving those or other price levels plays an important role in option trading. Using options, the trader, somehow, uses the concept of probability. This can be a probability of achieving some important technical levels, the probability of making a profit or loss, the probability of achieving the strike – these indicators are needed to assess risks of the selected option strategy. Using option module “Option master”, the trader can hold a probabilistic analysis of the position and more accurately assess the potential risks. To do this, it is enough to open “Option master”, create option position, and indicate price level that is interested for us using a corresponding vertical line in the “Analyzer” tab.

The probability of achieving the price level of 1844 points for the lifespan of the selected option contract is 29.49%.

Current example shows that the probability of achieving the price level of 1844 points for the lifespan of the selected option contract is 29.49%.

Time trading

We know that over time the option loses its time value. Greek “Theta” characterizes the sensitivity of option price to the reduction of the option lifespan. The higher the “Theta”, the stronger the time decay. Time decay increases its intensity as it approaches to the expiration date. The most significantly "Theta" affects the time value of the option in the last 2 weeks prior to expiration. To illustrate the dynamics of the time decay, we can say that, on average, for the options “at the money”, one-week option will “disintegrate” two times faster than the option with the expiration a month later. There is a type of option strategies that are focused on making a profit exactly owing to the time decay of the options. In this case, the trader strives to create a position which will be the least sensitive to the underlier movement and changes in volatility. Let’s consider an example of changing the cost of long Put option with strike price 2000 on the March contract of index S&P mini.

Two additional lines are shown on the position profile which reflects the theoretical option cost at invariable volatility

Two additional lines are shown on the position profile which reflects the theoretical option cost at invariable volatility through one (blue line) and three days (green line). Since before the expiration of this option series only four days remains, it is difficult to underestimate the influence of “Theta”. It reduces the option cost of more than on 50 % in two day.

Character of “Theta” for the options “at the money”, “out of the money” and options “in the money” is similar to “Vega”. Namely, “Theta” is maximal for options “at the money” and is minimal for options far “in the money” and far “out of the money”. Let’s consider the chart of changing “Theta” below, for long Put option on the March contract of index S&P mini with the strike price 2010.

The chart of changing “Theta” below, for long Put option on the March contract of index S&P mini with the strike price 2010.

If a trader supposes that the underlier price and volatility will be slightly changed in a certain time frame, then it would be logical to create a short option position which will be focused on making a profit owing to the time decay. For such position, based on the written above dependency for the “Theta” it is worth selecting the options closest to the state “at the money”. In this case, the closest option contract to expiration is preferable.

Separation of the option strategies into three described above types is conditional, since each option position in one or another way depends on volatility and the underlier price, and on time till expiration. Success of the option trading is to understand the influence degree of above-listed factors on the selected option strategy. That, in its turn, gives a possibility to effectively manage the option position according to the changes in the market situation.

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