Source: BURSA | Published: October 2021
If you trade stocks; you might have heard of the word “vitality”. Volatility is generally known as a measure of risk. Put simply, the concept of volatility refers to the likelihood of a security’s price to move higher or lower within a given time period. Does it work the same way when it comes to options trading?
When compared to stocks, volatility has a greater impact on options trading. This is due to the fact that implied volatility is one of the major factors which determines the price that you sell, or purchase an options contract at. Additionally, fluctuations in implied volatility suggests that the market expects price movements of the underlying security. Take stock options for example, when there is a foreseeable major event such as an earnings release or regulatory announcement, implied volatility would often rise as the market anticipates how the stock would react to the news. In this case, the increase in implied volatility will result in higher options premiums under the assumption that all other factors remain constant. The reverse would then happen once the event has lapsed as the news has already caused a change in the stock price. The drop in implied volatility will then push options prices lower.
However, implied volatility is not the only factor impacting the value of options. In fact, options could be a valuable addition to an investment portfolio, especially during turbulent times.
But first, let’s learn about the basics.
What are Options?
Options are financial instruments that give the holder the right, but not the obligation to buy or sell a security at a pre-agreed price by a certain expiration date. Options minimize the risk for buyers by fixing a predetermined future price for the underlying asset, without an obligation for option buyers to purchase the underlying security.
Sellers of an options contract, also known as “options writers”, have no rights and must sell the underlying security at the pre-determined price if the buyer chooses to execute the contract by the expiration date. This is done in exchange for payment from the buyer which is known as the “premium”.
There are two kinds of options – a call and a put. A call options grants the holder the right to buy the underlying security, while a put options grants the holder the right to sell it. You can also sell call or put options but you are obliged to buy or sell the security at the set price, known as the “strike price”, given that the options are executed by the buyer by the expiry date.
There is more flexibility in your investments when it comes to options trading since options contracts can also include other types of underlying securities such as ETFs, indices and commodities. You can use options as a form of insurance or hedge for your portfolio risk, to generate income or even to capitalize on short-term price movements.
For instance, say you own stocks in a company and are worried that its price may fall in the near future. You can opt to buy put options on your stock to hedge against the risk. Should your stock price fall below the strike price at expiry, gains from the options will help to offset your financial losses caused by the dropping stock price. If the reverse happens, your loss will be limited to the premium paid to buy the options contract.
Options can also help to reduce volatility in your portfolio. A covered call, for example, involves selling or writing options against your current security holdings then receiving an upfront premium which will help to generate cash flows or income for your portfolio.
Deeper Analysis of Options Trading
Now, let’s understand how options trading works. Similar to how stocks and bonds are traded, options contracts can also be traded. The main difference is that you do not have ownership of the underlying security. However, if you are the owner of the options contract, you will have the choice to purchase the underlying security, which means you could be eligible for ownership on account of the agreed terms.
Options Trading Strategies
There are countless strategies you can use when trading options. As previously discussed, higher volatility will generally increase the price of an options. One of the most common options trading strategies is buying call options when you expect volatility of the underlying security to increase. Once your expectations materialize and your options price rises as a result, you will then be able to profit by selling your options before expiry. Alternatively,
you may also hold your options until the expiration date and execute it if the market price increases above the strike price. In this strategy, your potential loss is only limited to the premium you paid to open the positions. Similarly, you can also trade put options if you expect the opposite to happen.
The Long Straddle Strategy
Another options trading strategy that aims to generate profit from high volatility is a long straddle. A long straddle is a dual-directional strategy; it is a combination of buying a call and a put with both options having the same underlying security, strike price and expiry dates. This strategy is typically useful when you expect a significant price movement, not knowing which direction the price will go, or if there will be an increase in implied volatility in the near future. High volatility is vital for this strategy to work. If the price remains steady or the price movement is not significant, one options contract would expire worthless and exercising the other options may not offset the cost of buying both options.
Application of the Long Straddle Strategy
For instance, Stock X is trading at RM20 and the value is expected to move significantly due to an imminent event. However, there is ambiguity as to which direction the price will move.
- You then purchase 100 call options contracts for RM200 (RM2 x 100) with strike price at RM20 as well as 100 put options contracts for a RM200 (RM2 x 100) cost.
- Your total cost for opening the positions is RM400 (RM200 + RM200).
(a) If Stock A is still trading at RM20 at expiry, your options will expire worthless and you will lose a total cost of RM400.
(b) However, if Stock A happens to trade at RM25, only the calls will be exercised and that will return you RM500 (RM5 x 100) profit and your overall profit will be RM100 (RM400 – RM500).
(c) On the other hand, if Stock A trades at RM12 at expiry, only the puts will be exercised and that will return you a RM800 (RM8 x 100) profit and your overall profit will be RM400 (RM800 - RM400).
This strategy is not of course without its risks. One important thing to note is that an increase in implied volatility also increases the risk of trading options. The cost of options will be higher, making breakeven points further. This will result in greater risk.
The Long Strangle Strategy
Another strategy to employ in a situation when the outlook is volatile is a long strangle. This strategy is similar to a long straddle with the difference being that both options in a long strangle have different strike prices. It consists of buying a call with a higher strike price and a put with a lower strike price. The cost of establishing a long strangle strategy is lower than a long straddle strategy, but the breakeven points deviate more in comparison to one another.
The Importance of Volatility in Options Trading
By now, it should be clear that volatility plays a very important role in options trading. The content covered explores basic strategies on how we can capitalize from options during times of uncertainty. It is crucial to be ready and equipped with the necessary information prior to trading into options.
Tags: Volatility, Trading, Derivatives
