Chapter 20 - Option Volatility Strategies Flashcards
What is delta?
The amount an option’s price is
expected to change given a one-unit
change in the price of the underlying
interest.
What is gamma?
The amount an option’s delta is
expected to change given a one-unit
change in the price of the underlying
interest.
What is a long straddle?
The strategy
A long straddle is the best of both worlds, since the call gives you the right to buy the stock at strike price A and the put gives you the right to sell the stock at strike price A. But those rights don’t come cheap.
The goal is to profit if the stock moves in either direction. Typically, a straddle will be constructed with the call and put at-the-money(or at the nearest strike price if there’s not one exactly at-the-money). Buying both a call and a put increases the cost of your position, especially for a volatile stock. So you’ll need a fairly significant price swing just to break even.
Advanced traders might run this strategy to take advantage of a possible increase in implied volatility. If implied volatility is abnormally low for no apparent reason, the call and put may be undervalued. The idea is to buy them at a discount, then wait for implied volatility to rise and close the position at a profit.
Options guys tips
Many investors who use the long straddle will look for major news events that may cause the stock to make an abnormally large move. For example, they’ll consider running this strategy prior to an earnings announcement that might send the stock in either direction.
If buying a short-term straddle (perhaps two weeks or less) prior to an earnings announcement, look at the stock’s charts. Look for instances where the stock moved at least 1.5 times more than the cost of your straddle. If the stock didn’t move at least that much on any of the last three earnings announcements, you probably shouldn’t run this strategy. Lie down until the urge goes away.
The setup
Buy a call, strike price A Buy a put, strike price A Generally, the stock price will be at strike A
Who should run it
Seasoned Veterans and higher
NOTE: At first glance, this seems like a fairly simple strategy.However, it is not suited for all investors. To profit from a longstraddle, you’ll require fairly advanced forecasting ability.
When to run it
Options Playbook image 2
You’re anticipating a swing in stock price, but you’re not sure which direction it will go.
Break-even at expiration
There are two break-even points:
Strike A plus the net debit paid. Strike A minus the net debit paid.
The sweet spot
The stock shoots to the moon, or goes straight down the toilet.
Maximum potential profit
Potential profit is theoretically unlimited if the stock goes up.
If the stock goes down, potential profit may be substantial but limited to the strike price minus the net debit paid.
Maximum potential loss
Potential losses are limited to the net debit paid.
Margin requirement
After the trade is paid for, no additional margin is required.
As time goes by
For this strategy, time decay is your mortal enemy. It will cause the value of both options to decrease, so it’s working doubly against you.
Implied volatility
After the strategy is established, you really want implied volatility to increase. It will increase the value of both options, and it also suggests an increased possibility of a price swing. Huzzah.
Conversely, a decrease in implied volatility will be doubly painful because it will work against both options you bought. If you run this strategy, you can really get hurt by a volatility crunch.
What is a long strangle?
The strategy
A long strangle gives you the right to sell the stock at strike price A and the right to buy the stock at strike price B.
The goal is to profit if the stock makes a move in either direction. However, buying both a call and a put increases the cost of your position, especially for a volatile stock. So you’ll need a significant price swing just to break even.
The difference between a long strangle and a long straddle is that you separate the strike prices for the two legs of the trade. That reduces the net cost of running this strategy, since the options you buy will be out-of-the-money . The tradeoff is, because you’re dealing with an out-of-the-money call and an out-of-the-money put, the stock will need to move even more significantly before you make a profit.
Options guys tips
Many investors who use the long strangle will look for major news events that may cause the stock to make an abnormally large move. For example, they’ll consider running this strategy prior to an earnings announcement that might send the stock in either direction.
Unless you’re dead certain the stock is going to make a very large move, you may wish to consider running a long straddle instead of a long strangle. Although a straddle costs more to run, the stock won’t have to make such a large move to reach your break-even points.
The setup
Buy a put, strike price A Buy a call, strike price B Generally, the stock price will be between strikes A and B
Who should run it
Seasoned Veterans and higher
NOTE: Like the long straddle, this seems like a fairly simple strategy. However, it is not suited for all investors. To profit from a long strangle, you’ll require fairly advanced forecasting ability.
When to run it
Options Playbook image 2
You’re anticipating a swing in stock price, but you’re not sure which direction it will go.
Break-even at expiration
There are two break-even points:
Strike A minus the net debit paid. Strike B plus the net debit paid.
The sweet spot
The stock shoots to the moon, or goes straight down the toilet.
Maximum potential profit
Potential profit is theoretically unlimited if the stock goes up.
If the stock goes down, potential profit may be substantial but limited to strike A minus the net debit paid.
Maximum potential loss
Potential losses are limited to the net debit paid.
Margin requirement
After the trade is paid for, no additional margin is required.
As time goes by
For this strategy, time decay is your mortal enemy. It will cause the value of both options to decrease, so it’s working doubly against you.
Implied volatility
After the strategy is established, you really want implied volatility to increase. It will increase the value of both options, and it also suggests an increased possibility of a price swing. Sweet.
Conversely, a decrease in implied volatility will be doubly painful because it will work against both options you bought. If you run this strategy, you can really get hurt by a volatility crunch.
What is rho?
The amount an option’s price is
expected to change given a 1% change
in the risk-free interest rate.
What is a short straddle?
The strategy
A short straddle gives you the obligation to sell the stock at strike price A and the obligation to buy the stock at strike price A if the options are assigned.
By selling two options, you significantly increase the income you would have achieved from selling a put or a call alone. But that comes at a cost. You have unlimited risk on the upside and substantial downside risk.
Advanced traders might run this strategy to take advantage of a possible decrease in implied volatility . If implied volatility is abnormally high for no apparent reason, the call and put may be overvalued. After the sale, the idea is to wait for volatility to drop and close the position at a profit.
Options guys tips
Even if you’re willing to accept high risk, you may wish to consider a short strangle since its sweet spot is wider than a short straddle’s.
The setup
Sell a call, strike price A Sell a put, strike price A Generally, the stock price will be at strike A
Who should run it
All-Stars only
NOTE: This strategy is only suited for the most advanced traders and not for the faint of heart. Short straddles are mainly for market professionals who watch their account full-time. In other words, this is not a trade you manage from the golf course.
When to run it
Options Playbook image 4
You’re expecting minimal movement on the stock. (In fact, you should be darn certain that the stock will stick close to strike A.)
Break-even at expiration
There are two break-even points:
Strike A minus the net credit received. Strike A plus the net credit received.
The sweet spot
You want the stock exactly at strike A at expiration, so the options expire worthless. However, that’s extremely difficult to predict. Good luck with that.
Maximum potential profit
Potential profit is limited to the net credit received for selling the call and the put.
Maximum potential loss
If the stock goes up, your losses could be theoreticallyunlimited.
If the stock goes down, your losses may be substantialbut limited to the strike price minus net credit received forselling the straddle.
Margin requirement
Margin requirement is the short call or short put requirement (whichever is great), plus the premium received from the other side.
NOTE: The net credit received from establishing the short straddle may be applied to the initial margin requirement.
After this position is established, an ongoing maintenance margin requirement may apply. That means depending on how the underlying performs, an increase (or decrease) in the required margin is possible. Keep in mind this requirement is subject to change and is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.
As time goes by
For this strategy, time decay is your best friend. It works doubly in your favor, eroding the price of both options you sold. That means if you choose to close your position prior to expiration, it will be less expensive to buy it back.
Implied volatility
After the strategy is established, you really want implied volatility to decrease. An increase in implied volatility is dangerous because it works doubly against you by increasing the price of both options you sold. That means if you wish to close your position prior to expiration, it will be more expensive to buy back those options.
An increase in implied volatility also suggests an increased possibility of a price swing, whereas you want the stock price to remain stable around strike A.
What is a short strangle?
The strategy
A short strangle gives you the obligation to buy the stock at strike price A and the obligation to sell the stock at strike price B if the options are assigned. You are predicting the stock price will remain somewhere between strike A and strike B, and the options you sell will expire worthless.
By selling two options, you significantly increase the income you would have achieved from selling a put or a call alone. But that comes at a cost. You have unlimited risk on the upside and substantial downside risk. To avoid being exposed to such risk, you may wish to consider using an iron condor instead.
Like the short straddle , advanced traders might run this strategy to take advantage of a possible decrease in implied volatility. If implied volatility is abnormally high for no apparent reason, the call and put may be overvalued. After the sale, the idea is to wait for volatility to drop and close the position at a profit.
Options guys tips
You may wish to consider ensuring that strike A and strike B are one standard deviation or more away from the stock price at initiation. That will increase your probability of success. However, the further out-of-the-money the strike prices are, the lower the net credit received will be from this strategy.
The setup
Sell a put, strike price A Sell a call, strike price B Generally, the stock price will be between strikes Aand B
Who should run it
All-Stars only
NOTE: This strategy is only for the most advanced traders who like to live dangerously (and watch their accounts constantly).
When to run it
Options Playbook image 2
You are anticipating minimal movement on the stock.
Break-even at expiration
There are two break-even points:
Strike A minus the net credit received. Strike B plus the net credit received.
The sweet spot
You want the stock at or between strikes A and B atexpiration, so the options expire worthless.
Maximum potential profit
Potential profit is limited to the net credit received.
Maximum potential loss
If the stock goes up, your losses could be theoretically unlimited.
If the stock goes down, your losses may be substantia but limited to strike A minus the net credit received.
Margin requirement
Margin requirement is the short call or short put requirement (whichever is greater), plus the premium received from the other side.
NOTE: The net credit received from establishing the short strangle may be applied to the initial margin requirement.
After this position is established, an ongoing maintenance margin requirement may apply. That means depending on how the underlying performs, an increase (or decrease) in the required margin is possible. Keep in mind this requirement is subject to change and is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.
As time goes by
For this strategy, time decay is your best friend. It works doubly in your favor, eroding the price of both options you sold. That means if you choose to close your position prior to expiration, it will be less expensive to buy it back.
Implied volatility
After the strategy is established, you really want implied volatility to decrease. An increase in implied volatility is dangerous because it works doubly against you by increasing the price of both options you sold. That means if you wish to close your position prior to expiration, it will be more expensive to buy back those options.
An increase in implied volatility also suggests an increased possibility of a price swing, whereas you want the stock price to remain stable between strike A and strike B.
What is theta?
The amount an option’s price is
expected to change given a reduction
in the time remaining until expiration.
What is vega?
The amount an option’s price is
expected to change given a 1% change
in volatility.
Differences between implied and historical (statistical) volatility
- Historical volatility, usually measured by the standard deviation of price returns, is the actual volatility exhibited
by a stock over a defined period. - Implied volatility is the average forecast of future volatility by options market participants.
- Together with the value of the other pricing factors, the value of future volatility that needs to be inputted into
an option-pricing model to arrive at the option’s current price is the implied volatility.
Historical Volatility (HV)
What it is: A measure of the actual past volatility of a security's price. How it’s measured: By calculating the standard deviation of the security's price changes over a specific past period. Time frame: Typically measured over 10, 30, 60, or 90 days, but can vary.
Implied Volatility (IV)
What it is: A measure of the market's expectation of future volatility. How it’s measured: Derived from the price of options using an options pricing model (like the Black-Scholes model). Time frame: Applies to the expiration date of the options, reflecting expected volatility until that date.
In summary:
Historical Volatility looks backward at actual price changes. Implied Volatility looks forward at expected price changes.
Option sensitivities
- Option sensitivities are often referred to as “the Greeks” because each sensitivity is represented by a Greek
letter. - The delta of an option measures how much the option’s theoretical value is expected to change given a
$1 increase in the underlying stock’s price. - The gamma of an option measures how much the delta of the option is expected to change given a $1 increase
in the underlying stock’s price. - The theta of an option measures how much the option’s theoretical value is expected to change given a
reduction in the time remaining until expiration. - The rho of an option measures how much the option’s theoretical value is expected to change given a
1% increase in the risk-free interest rate. - The vega of an option measures how much the option’s theoretical value is expected to change given a
1% increase in volatility.
Low volatility
- Volatility can be considered low if implied volatility is lower than historical volatility or if implied volatility is
lower than historical implied volatility.
High volatility
- Volatility can be considered high if implied volatility is greater than historical volatility or if implied volatility is
greater than historical implied volatility.
Option strategies that take advantage of declining volatility
- Short straddles and short combinations can be used to take advantage of declining volatility.
- A short straddle involves simultaneously writing a call option and a put option on the same underlying interest
with the same strike price and the same expiration date. - A short combination – also known as a short strangle – involves simultaneously writing a call option and a put
option on the same underlying interest and the same expiration date, but with different strike prices. - While not a strict requirement, in a short combination, the strike price of the call is usually higher than the
strike price of the put.
Option strategies that take advantage of increasing volatility
- Long straddles, long combinations and time spreads can be used to take advantage of increasing volatility.
- A long straddle involves simultaneously buying a call option and a put option on the same underlying interest
with the same strike price and the same expiration date. - A long combination – also known as a long strangle – involves simultaneously buying a call option and a put
option on the same underlying interest and the same expiration date, but with different strike prices. - While not a strict requirement, in a long combination, the strike price of the call is usually higher than the strike
price of the put. - A time spread – also known as a calendar spread – involves buying and writing an equal number of either puts or
calls on the same underlying interest with different expiration dates and the same strike price. - To be eligible for spread margining, the long side of a time spread must expire after the short side.
