Market volatility and options prices go hand-in-hand. Demand for options goes up or down as investors’ sentiment changes regarding market volatility.
Options are a form of financial contracts that allow the buyer a right to buy or sell (depending on the type of contract) an underlying asset at an agreed-upon price and date. It has two variants – call and put.
- Call option – It allows the buyer to buy an asset at a predetermined price within a specific time frame.
- Put option – It will enable the owner of the contract to sell an asset at a future date at an agreed-upon price.
Although it is a contract, it doesn’t impose any obligation. Each option has an expiration date and becomes invalid if the owner chooses not to exercise his rights. It is a decision he takes based on his outlook on market volatility. An option is said to be in-the-money (ITM) when it has intrinsic value and time value, and worth trading. Otherwise, the owner may decide not to trade if its benefits get nullified. So, options sell in a very different manner than the other asset classes traded in the exchange.
How To Calculate The Price Of An Option
Options prices are determined by seven factors, of which six factors are known to the trader. The seventh factor is volatility. To plan an option strategy, one must understand how the volatility factor impacts options prices.
1. Type of options – decided
2. Underlying asset price – known
3. Strike price – decided
4. Expiration date – known
5. Risk-free interest rate – known
6. Dividend on underlying asset – known
7. Market volatility (implied volatility) – unknown
It makes option volatility and pricing strategies one of the most frequently discussed topics.
Option Prices And Market Volatility
Implied volatility is a crucial factor in deciding the future value of an option. While all the other factors are known, options prices can still change if there are degrees of changes in implied volatility.
What is Implied Volatility (IV)? It is a forecast on the likely price changes of an underlying asset which will impact option price. It influences the time value of an option.
Apart from IV, there is also historical volatility, which is an index of actual volatility demonstrated by the market. However, IV has a more significant impact on options prices than historical volatility since it predicts future changes. Historical and implied volatility of a stock or asset can show contradicting trends. However, it is still sensible to compare both to get an idea of what might be lying ahead. Being said that, it becomes essential to have an option strategy for high volatility to strike a successful trade.
Planning With Option Volatility And Pricing Strategies
The market recognises five established option volatility and pricing strategies to plan a trade around IV. We have listed them below.
Naked call and put strategy
Although the most uncomplicated strategy to implement, it is reserved for the experienced traders only. Why? The risk exposure is so high that loss will be unlimited if your predictions go wrong.
When the price of an underlying is bullish, but you expect high volatility, you sell an out-of-the-money put option. It is a policy that works best when the market sentiment remains between bullish and neutral.
Similarly, a trader can write a naked call if he assumes the market to stay bearish. He sells an out-of-the-money call option and makes a profit when the underlying price falls.
Consider it with an example. Suppose the value of XYZ stocks declined by 20 percent after rising for a year. The current price of the stock is Rs 91. The trader can buy the shares at RS 90 strike price with an expiration date in August 2020. The current price of the put is Rs 11.40 with an IV of 53 percent, which means for the put option to become profitable in August its price must further decline by Rs 12.55 or 14 percent.
Conversely, a trader will write a naked call option if he expects the market to remain bearish. If the stocks close below Rs 90 in August, the trader can keep the entire premium amount and make a profit from the deal.
However, there is one word of caution, writing naked call or put carries unlimited risk exposure, and you can end up accumulating colossal loss if your strategy doesn’t match with the trend. Often to hedge against a risk exposure, traders enter into a spread by adding a short put/call position into the deal.
Short Strangle and Straddle: In a straddle deal, when market volatility is high, a trader writes (sells) both call and put options at the same strike price to receive premiums from both. He expects IV to reduce around the time of expiration, thus allowing him to retain premium from both options (Rs 12.35 + Rs11.10 = Rs 23.45).
A short strangle strategy is also similar to a short straddle condition. But in a strangle situation the strike prices of call and put options don’t remain the same. The thumb rule indicates that the call strike price remains higher than the put strike price.
Continuing with the above example, if we assume the underlying stock to close above Rs 66.55 (strike price Rs 90 – premium received Rs 23) or below Rs 113.45 (Rs 90 + Rs 23.45) the deal will be profitable.
Profit possibility in a strangle condition is lower than the straddle, but it offers you a broader range to reduce risk.
Iron condors: If you liked the idea of short strangle, but don’t like the risk involved in it, then iron condor is your option. It consists of trading a pair of out-of-the-money spreads each on call and put sides to increase chances of profit and lower risk volume.
Options trading involves optimising profit when market trends are expected to reverse. When IV is high, plan for a selling strategy. High volatility will keep the prices of your options high and let you leverage higher profit. As an investor, you need to carefully weigh your risks to be on the right side of the market trend to plan a successful options trading strategy.