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What Is Options Trading? Examples and Strategies in 2018
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The three dimensions are price of the underlying , time, and volatility. The most misunderstood and neglected dimension, and often the last thing a novice trader learns about, is volatility. However, an options trader needs to understand volatility and appreciate its effects. No savvy trader ever buys or sells an option without awareness of the current volatility scenario. Many sophisticated options traders go beyond that, choosing to focus on volatility as the main aspect of their trading while neutralizing the other factors.
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How do they do this, and why? The essence of volatility based trading, or V-trading for short, is buying options when they are cheap and selling options when they are dear. The reason it's called volatility based trading comes from the way we measure cheapness or dearness — using a parameter called implied volatility or IV for short. We'll discuss IV in more detail below, but for now, it will suffice to say that high IV is synonymous with expensive options; low IV is synonymous with cheap options.
Measuring premium levels is one thing; judging good trading opportunities is another. There are two ways of judging the cheapness or dearness of options. The first is simply by comparing current IV with past levels of IV on the same underlying asset. The second is by comparing current implied volatility with the volatility of the underlying itself. Both approaches are important and come into play in all V-trading decisions.
The most attractive opportunities are when options are cheap or dear by both measures. The volatility trader typically uses puts and calls in combination, selecting the most appropriate strikes, durations, and quantities, to construct a position that is said to be "delta neutral". A delta neutral position has nearly zero exposure to small price changes in the underlying. Sometimes the trader has a directional opinion and deliberately biases his position in favor of the expected underlying trend.
However, more often the V-trader is focused on making money just from volatility, and is not interested in trying to make money from underlying price changes. Once a position is set up, it is simply held and then adjusted when necessary to re-establish the appropriate delta. These adjustments can be costly, in terms of transaction costs, and should be minimized, but not to the point where you expose yourself to too much delta risk. My rule is: "If you give the market a chance to take money away from you through delta , it will.
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Once option prices return to a more normal, average level as measured by IV , then the position can be closed. If not too many adjustments were required in the meantime, the trader should see a profit.
Since options are extremely sensitive to changes in implied volatility, trading options on the basis of volatility can be lucrative. Occasionally, options become way too expensive or way too cheap. In these situations the V-trader has a considerable edge. The investor can always count on volatility returning to normal levels after going to an extreme. This principle is called "the mean reversion tendency of volatility", and it is the foundation of volatility based trading. That volatilities "mean revert" is well established in many academic publications 1. You can also see it for yourself just by looking at a few historical volatility charts.
You will notice that when volatility goes to an extreme level, it always comes back to "normal". It may not happen right away. It may take anywhere from days to months, but sooner or later it always comes back. Implied volatilities seem to change from week to week, if not day to day.
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V-Traders find profit opportunities in this. Others find these volatility changes a nuisance and a hazard. V-Trader or not, you need to pay attention to volatility. Since we measure how expensive or cheap options are using a parameter called implied volatility, or IV for short, it is important to understand IV. The term implied volatility comes from the fact that options imply the volatility of their underlying, just by their price. A computer model starts with the actual market price of an option, and measures IV by working the option fair value model backward, solving for volatility normally an input as if it were the unknown.
Actually, the fair value model cannot be worked backward, and has to be worked forward repeatedly through a series of intelligent guesses until the volatility is found that makes fair value equal to the market price of the option. Again, high IV is synonymous with expensive options; low IV is synonymous with cheap options. It is useful to plot an asset's IV over a period of years, to see the extent of its highs and lows, and to know what constitutes a normal, or average level.
We measure how much the price of an asset bounces around using a parameter called statistical volatility, or SV for short. There are several different computer models for measuring SV. All of them seek to quantify the extent, or magnitude, of the asset's price swings on a percentage basis, and use varying periods of the asset's recent price history for example, 10, 20 or 30 days.
SV can also be plotted, so that the investor can see the periods of relative price activity and inactivity over time. Note: Much of the industry calls this historical volatility, but we prefer to call it statistical volatility, reserving the word historical for its true meaning — that of referring to the history of IV and SV. Regardless of the length of the sample period, SV is always normalized to represent a one-year, single standard deviation price move of the underlying asset. IV is also normalized to the same standard.
Thus IV and SV are directly comparable, and it is very useful to see them plotted together. When the options of a particular asset are more expensive than usual, sometimes that additional expense is justified by unusually high volatility in the underlying. While this may be a decent opportunity to sell options, it is even more advantageous to sell options when the extra IV is not accompanied by extra SV.
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