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Option Volatility and Pricing Strategies – Explained

4 Mins 23 Jun 2023 0 COMMENT

Options trading is rapidly becoming more popular. Many traders are attracted to options trading as it can help them earn a significant profit in a relatively short time. Moreover, since these contracts offer leverage, traders do not need large capital to deploy some strategies. However, options trading can be risky if not done correctly. It is of utmost importance that a trader knows the basics of options along with options volatility and pricing.

What is Option Volatility?

When it comes to trading options, a trader should know the various factors and variables that affect the price of an option contract. There are a total of 7 variables that affect an option’s price.

Out of the 7 variables, 6 have fixed values which are used in the option pricing model, but volatility is estimated. Here are the variables which affect option pricing.

  • Underlying security’s price
  • Option’s type - Call or put option
  • Time to expiry of the option
  • Risk-free interest rate
  • Dividends offered by the underlying
  • Strike price
  • Volatility

Volatility is variable. It does not have a fixed value. Implied Volatility (IV) has a significant impact on option prices. IV is a forecast of the volatility of the underlying asset’s price. Option premiums tend to go higher with higher IV. Apart from IV, traders should also know and study Historic Volatility (HV). Historic volatility is the volatility of an underlying over a period. However, IV plays a more relevant role in options trading as it can help forecast future volatility.

Option Volatility Trading Strategies

Before learning about option volatility pricing strategies, let us go over the basics of options.

Options are derivative contracts which give the holder the right to purchase or sell the underlying asset but not the obligation. A seller of an options contract is obligated to perform his duty if the holder exercises their right.

Being a derivative contract, options don’t have any intrinsic value of their own. They derive their value from their underlying asset. A change in the price of the underlying asset will affect the change in the price or premium of the options contract.

Types of Options Contracts:

Call options

Call options are option contracts whose value increases with an increase in the price of the underlying and vice versa.

Put Options

Put options are option contracts whose value increases with a fall in the price of the underlying. Put option premiums are inversely related to the price of the underlying.

With the help of IV, a trader can make use of certain option volatility pricing strategies. Here are a few widely used strategies:

Naked Call or Put

Buying or selling naked options is an easy-to-execute strategy. Although this strategy may be simple, it requires a certain amount of experience as a trader to make the most of it. It involves buying or selling options without actually holding the underlying asset.

In this strategy, a naked put option is sold when the market sentiment is expected to be bullish with some degree of volatility. As the market moves higher, the trader can profit from the rising premium of the put option. Conversely, when the underlying’s price is expected to go down, a trader can sell a call option and profit. However, selling naked options carry unlimited risk and trends can reverse quickly in volatile times.

Short Strangle and Short Straddle

In a short straddle, both call and put options of the same strike price are sold. A straddle strategy is used when the trader anticipates IV to fall near expiration. This allows a trader to keep the premium from both options.

Meanwhile, in a short strangle strategy, the call and put options with different strike prices are sold. The strike price of the call option will always be higher than the strike price of the put option.

Short strangle and short straddle are non-directional strategies in which the IV is expected to fall as expiration nears. Short straddle strategies tend to have a higher profit potential than short strangles.

Iron Condor

Iron Condors involve trading out-of-the money call and put option spreads. Iron condors increase the potential of profit while making it relatively less risky than a short strangle. In this strategy, a trader goes long on a call and put option and short on one call and one put option. All 4 option contracts have to be of different strike prices.

Ratio writing

Ratio writing is a method of trading in which a ratio is applied to options sold and bought. For example, a ratio of 2:1 means that a trader will sell two options for every option bought. The aim of this strategy is to profit from the decrease in IV as expiry approaches.

Understanding IV can help traders formulate trading strategies. We can understand this better with an example.

When the IV of an underlying is high, it will lead to higher premiums. Traders can take advantage of this and opt for a selling strategy in which the drop in IV will erode the premium and help the trader pocket a larger profit. Similarly, when the IV is low, traders can opt for a non-directional strategy and benefit from the drop in IV as expiry approaches.

In conclusion, options trading can prove to be very useful for traders as well as investors. Having a good grasp of the basics and concepts like implied volatility can help a trader minimize losses and generate returns in various market conditions. However, options trading can carry significant risks and it is crucial to follow proper risk management principles while trading.

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