How To Trade Volatility – Chuck Norris Style!

When trading options, one of the hardest concepts for beginner traders to learn is volatility, and specifically HOW TO TRADE VOLATILITY. After receiving numerous emails from people regarding this topic, I wanted to take an in depth look at option volatility. I will explain what option volatility is and why it’s important. I’ll also discuss the difference between historical volatility and implied volatility and how you can use this in your trading, including examples. I’ll then look at some of the main options trading strategies and how rising and falling volatility will affect them. This discussion will give you a detailed understanding of how you can use volatility in your trading.

OPTION TRADING VOLATILITY EXPLAINED

Option volatility is a key concept for option traders and even if you are a beginner, you should try to have at least a basic understanding. Option volatility is reflected by the Greek symbol Vega which is defined as the amount that the price of an option changes compared to a 1% change in volatility. In other words, an options Vega is a measure of the impact of changes in the underlying volatility on the option price. All else being equal (no movement in share price, interest rates and no passage of time), option prices will increase if there is an increase in volatility and decrease if there is a decrease in volatility. Therefore, it stands to reason that buyers of options (those that are long either calls or puts), will benefit from increased volatility and sellers will benefit from decreased volatility. The same can be said for spreads, debit spreads (trades where you pay to place the trade) will benefit from increased volatility while credit spreads (you receive money after placing the trade) will benefit from decreased volatility.

Here is a theoretical example to demonstrate the idea. Let’s look at a stock priced at 50. Consider a 6-month call option with a strike price of 50:

If the implied volatility is 90, the option price is $12.50
If the implied volatility is 50, the option price is $7.25
If the implied volatility is 30, the option price is $4.50

This shows you that, the higher the implied volatility, the higher the option price. Below you can see three screen shots reflecting a simple at-the-money long call with 3 different levels of volatility.

The first picture shows the call as it is now, with no change in volatility. You can see that the current breakeven with 67 days to expiry is 117.74 (current SPY price) and if the stock rose today to 120, you would have $120.63 in profit.

How to trade volatility1

The second picture shows the call same call but with a 50% increase in volatility (this is an extreme example to demonstrate my point). You can see that the current breakeven with 67 days to expiry is now 95.34 and if the stock rose today to 120, you would have $1,125.22 in profit.

how to trade volatility2

The third picture shows the call same call but with a 20% decrease in volatility. You can see that the current breakeven with 67 days to expiry is now 123.86 and if the stock rose today to 120, you would have a loss of $279.99.

how to trade volatility3

WHY IS IT IMPORTANT?

One of the main reasons for needing to understand option volatility, is that it will allow you to evaluate whether options are cheap or expensive by comparing Implied Volatility (IV) to Historical Volatility (HV).

Below is an example of the historical volatility and implied volatility for AAPL. This data you can get for free very easily from www.ivolatility.com. You can see that at the time, AAPL’s Historical Volatility was between 25-30% for the last 10-30 days and the current level of Implied Volatility is around 35%. This shows you that traders were expecting big moves in AAPL going into August 2011. You can also see that the current levels of IV, are much closer to the 52 week high than the 52 week low. This indicates that this was potentially a good time to look at strategies that benefit from a fall in IV.

Implied Volatility Trading

Here we are looking at this same information shown graphically. You can see there was a huge spike in mid-October 2010. This coincided with a 6% drop in AAPL stock price. Drops like this cause investors to become fearful and this heightened level of fear is a great chance for options traders to pick up extra premium via net selling strategies such as credit spreads. Or, if you were a holder of AAPL stock, you could use the volatility spike as a good time to sell some covered calls and pick up more income than you usually would for this strategy. Generally when you see IV spikes like this, they are short lived, but be aware that things can and do get worse, such as in 2008, so don’t just assume that volatility will return to normal levels within a few days or weeks.

Volatility Trading

Every option strategy has an associated Greek value known as Vega, or position Vega. Therefore, as implied volatility levels change, there will be an impact on the strategy performance. Positive Vega strategies (like long puts and calls, backspreads and long strangles/straddles) do best when implied volatility levels rise. Negative Vega strategies (like short puts and calls, ratio spreads and short strangles/ straddles) do best when implied volatility levels fall. Clearly, knowing where implied volatility levels are and where they are likely to go after you’ve placed a trade can make all the difference in the outcome of strategy.

HISTORICAL VOLATILITY AND IMPLIED VOLATILITY

We know Historical Volatility is calculated by measuring the stocks past price movements. It is a known figure as it is based on past data. I want go into the details of how to calculate HV, as it is very easy to do in excel. The data is readily available for you in any case, so you generally will not need to calculate it yourself. The main point you need to know here is that, in general stocks that have had large price swings in the past will have high levels of Historical Volatility. As options traders, we are more interested in how volatile a stock is likely to be during the duration of our trade. Historical Volatility will give some guide to how volatile a stock is, but that is no way to predict future volatility. The best we can do is estimate it and this is where Implied Vol comes in.

- Implied Volatility is an estimate, made by professional traders and market makers of the future volatility of a stock. It is a key input in options pricing models.

- The Black Scholes model is the most popular pricing model, and while I won’t go into the calculation in detail here, it is based on certain inputs, of which Vega is the most subjective (as future volatility cannot be known) and therefore, gives us the greatest chance to exploit our view of Vega compared to other traders.

- Implied Volatility takes into account any events that are known to be occurring during the lifetime of the option that may have a significant impact on the price of the underlying stock. This could include and earnings announcement or the release of drug trial results for a pharmaceutical company. The current state of the general market is also incorporated in Implied Vol. If markets are calm, volatility estimates are low, but during times of market stress volatility estimates will be raised. One very simple way to keep an eye on the general market levels of volatility is to monitor the VIX Index.

 

HOW TO TAKE ADVANTAGE BY TRADING IMPLIED VOLATILITY

The way I like to take advantage by trading implied volatility is through Iron Condors. With this trade you are selling an OTM Call and an OTM Put and buying a Call further out on the upside and buying a put further out on the downside. Let’s look at an example and assume we place the following trade today (Oct 14,2011):

Sell 10 Nov 110 SPY Puts @ 1.16
Buy 10 Nov 105 SPY Puts @ 0.71
Sell 10 Nov 125 SPY Calls @ 2.13
Buy 10 Nov 130 SPY Calls @ 0.56

For this trade, we would receive a net credit of $2,020 and this would be the profit on the trade if SPY finishes between 110 and 125 at expiry. We would also profit from this trade if (all else being equal), implied volatility falls.

The first picture is the payoff diagram for the trade mentioned above straight after it was placed. Notice how we are short Vega of -80.53. This means, the net position will benefit from a fall in Implied Vol.

Trading Implied Volatility

The second picture shows what the payoff diagram would look like if there was a 50% drop in Implied vol. This is a fairly extreme example I know, but it demonstrates the point.

Trading Implied volatility2

The CBOE Market Volatility Index or “The VIX” as it is more commonly referred is the best measure of general market volatility. It is sometimes also referred as the Fear Index as it is a proxy for the level of fear in the market. When the VIX is high, there is a lot of fear in the market, when the VIX is low, it can indicate that market participants are complacent. As option traders, we can monitor the VIX and use it to help us in our trading decisions. Watch the video below to find out more.

There are a number of other strategies you can when trading implied volatility, but Iron condors are by far my favorite strategy to take advantage of high levels of implied vol. The following table shows some of the major options strategies and their Vega exposure.

Strategy
Vega
Delta
Theta
Max Loss
Max Gain
Experience Level
Long CallPositivePositiveNegativeLimitedUnlimitedBeginner
Long PutPositiveNegativeNegativeLimitedUnlimitedBeginner
Covered CallPositivePositivePositiveLimitedLimitedBeginner
Bull Call SpreadPositivePositiveNegativeLimitedLimitedBeginner
Bear Put SpreadPositiveNegativeNegativeLimitedLimitedBeginner
Bear Call SpreadNegativeNegativePositiveLimitedLimitedIntermediate
Bull Put SpreadNegativePositivePositiveLimitedLimitedIntermediate
Calendar SpreadPositiveNeutralPositiveLimitedLimitedAdvanced
Butterfly SpreadNegativeNeutralPositiveLimitedLimitedIntermediate
Long StraddlePositiveNeutralNegativeLimitedUnlimitedExpert
Long StranglePositiveNeutralNegativeLimitedUnlimitedExpert
Long Iron CondorNegativeNeutralPositiveLimitedLimitedAdvanced
Short StraddleNegativeNeutralPositiveUnlimitedLimitedExpert
Short StrangleNegativeNeutralPositiveUnlimitedLimitedExpert
Short Iron CondorPositiveNeutralNegativeLimitedLimitedExpert
Short PutNegativePositivePositiveLimitedLimitedIntermediate
Short CallNegativeNegativePositiveUnlimitedLimitedAdvanced
Ratio Put SpreadNegativePositivePositiveUnlimitedLimitedExpert
Ratio Call SpreadNegativeNegativePositiveUnlimitedLimitedExpert
Ratio Put BackspreadPositiveNegativeNegativeLimitedUnlimitedExpert
Ratio Call BackspreadPositivePositiveNegativeLimitedUnlimitedExpert

I hope you found this information useful. Let me know in the comments below what you favorite strategy is for trading implied volatility.

Here’s to your success!

The following video explains some of the ideas discussed above in more detail.

Leave A Reply (27 comments So Far)


  1. Gavin McMaster
    2 years ago

    With volatility looking like it may be spiking back up again, now is a great time to review this article.


  2. Bruce
    2 years ago

    Thanks for the explaination, really clear and concise. This has helped me greatly with the iron condor strategy.


    • Options Trading IQ
      2 years ago

      Glad to hear it Bruce.  Let me know if there is anything else I can help you with.


  3. Options Trading IQ
    2 years ago

    haha thanks, I appreciate the feedback.  Let me know if there’s is anything you think the site is missing.


  4. djohnsonhot
    2 years ago

    Great Commentary and clear as a BELL!


  5. dj94080
    2 years ago

    I typically trade AAPL weekly options via verticals/iron condors. This wk with earnings on 10/25 the IV is extremely high and AApl like GOOG can have a huge move. Do you prefer the stangle/straddle strategies in a wk like this?


    • Options Trading IQ
      2 years ago

      Typically I stay away from the weeklies to be honest, unless I am using them for a short-term hedge


  6. HelloWorld
    2 years ago

    Clear n great illustration :). Need ur help on clarification. A long butterfly is a debit spread, why would it be suitable for decreased implied volatility compared to other debit spread? Thank you.


    • HelloWorld
      2 years ago

      Is it due to the higher Vega on both the 2 ATM Call compared to both vegas of 1 ITM n 1 OTM? tq :).


  7. Sam Mujumdar
    2 years ago

    This article was so good!!! It answered lot of questions that I had. Very clear and explained in simple English. Thanks for your help. I was looking to understand the effects of Vol and how to use it to my advantage. This really helped me. I do still would like to clarify one question. I see that Netflix Feb 2013 Put options have volatility at 72% or so while the Jan 75 Put option vol is around 56. I was thinking of doing a OTM Reverse Calendar spread ( I had read about it) However, my fear is that the Jan Option would expire on the 18th and the vol for Feb would still be the same or more. I can only trade spreads in my account (IRA). I can not leave that naked option till the vol drops after the earnings on 25th Jan. May be I will have to roll my long to March—but when the vol drops—-????


  8. TonioTheOptionNoob
    2 years ago

    If I buy a 3month S&P ATM call option at the top of one of those vol spikes (I understand Vix is the implied vol on S&P), how do I know what takes precedence on my P/L : 1.) I will profit on my position from a rise in the underlying (S&P) or, 2.) I will lose on my position from a crash in volatility?


    • Options Trading IQ
      2 years ago

      Hi Tonio, there are lots of variable at play, it depends on how far the stock moves and how far IV drops. As a general rule though, for an ATM long call, the rise in the underlying would have the biggest impact.


    • Jim Caron
      1 year ago

      Remember: IV is the price of an option. You want to Buy puts and calls when IV is below normal, and Sell when IV goes up.

      Buying an ATM call at the top of a volatility spike is like having waited for the Sale to end before you went shopping… In fact, you may even have paid HIGHER than “retail,” if the premium you paid was above the Black-Scholes “fair value.”

      On the other hand, option pricing models are rules of thumb: stocks often go much higher or lower than what has happened in the past. But it’s a good place to start.

      If you own a call — say AAPL C500 — and even though the stock price of is unchanged the market price for the option just went up from 20 bucks to 30 bucks, you just won on a pure IV play.


  9. Daniel Marquard
    1 year ago

    Good read. I appreciate the thoroughness.

    -Daniel, Trading Vega


  10. Jim Caron
    1 year ago

    I don’t understand how a change in volatility affects the profitability of a Condor after you’ve placed the trade.

    In the example above, the $2,020 credit you earned to initiate the deal is the maximum amount you will ever see, and you can lose it all — and much more — if stock price goes above or below your shorts. In your example, because you own 10 contracts with a $5 range, you have $5,000 of exposure: 1,000 shares at 5 bucks each. Your max out-of-pocket loss would be $5,000 minus your opening credit of $2,020, or $2,980.

    You will never, ever, EVER have a profit higher than the 2020 you opened with or a loss worse than the 2980, which is as bad as it can possibly get.

    However, the actual stock movement is completely non-correlated with IV, which is merely the price traders are paying at that moment in time. If you got your $2,020 credit and the IV goes up by a factor of 5 million, there is zero affect on your cash position. It just means that traders are currently paying 5 million times as much for the same Condor.

    And even at those lofty IV levels, the value of your open position will range between 2020 and 2980 — 100% driven by the movement of the underlying stock. Your options remember are contracts to buy and sell stock at certain prices, and this protects you (on a condor or other credit spread trade).

    It helps to understand that Implied Volatility is not a number that Wall Streeters come up with on a conference call or a white board. The option pricing formulas like Black Scholes are built to tell you what the fair value of an option is in the future, based on stock price, time-to-expire, dividends, interest and Historic (that is, “what has actually happened over the past year”) volatility. It tells you that the expected fair price should be say $2.

    But if people are actually paying $3 for that option, you solve the equation backwards with V as the unknown: “Hey! Historic volatility is 20, but these people are paying as if it was 30!” (hence “Implied” Volatility)

    If IV drops while you are holding the $2,020 credit, it gives you an opportunity to close the position early and keep SOME of the credit, but it will always be less than the $2,020 you took in. That’s because closing Credit position will always require a Debit transaction. You can’t make money on both the in and the out.

    With a Condor (or Iron Condor which writes both Put and Call spreads on the same stock) your best case is for the stock to go flatline the moment you write your deal, and you take your sweetie out for a $2,020 dinner.


    • dattaway
      5 months ago

      My understanding is that if volatility decreases, then the value of the Iron Condor drops more quickly than it would otherwise, allowing you to buy it back and lock in your profit. Buying back at 50% max profit has been shown to dramatically improve your probability of success.


      • Options Trading IQ
        5 months ago

        Yes, that’s exactly right. Apologies Jim Caron, I must have missed replying to your initial comment.


  11. Antonio Scaletti
    1 year ago

    How would you replicate/replace an equity portfolio that is $50k long IWM and $50k short SPY with options? I tried buying ATM SPY puts where my notional was $50k and buying IWM calls where my notional was $50k, but I’ve found it essentially becomes a long straddle/volatility. please help


    • Options Trading IQ
      1 year ago

      You would be better off doing that with futures.


    • Options Trading IQ
      1 year ago

      In order to replicate a long position in a stock using options, you would sell and ATM put and buy and ATM call.

      A synthetic short position would be sell 1 ATM call,buy 1 ATM put.


  12. Ivan
    10 months ago

    Just found your site on facebook. Fantastic site, I love how you break down some difficult topic and communicate them in a very easy to understand fashion. Keep up the good work


    • Options Trading IQ
      10 months ago

      Thanks Ivan! You’re actually the second person to say that this week, so I must be doing something right. :)

      Thanks for your comment.


  13. Blueribbonoptionsonline
    8 months ago

    Of course we know you put in a deliberate mistake too see if we are paying attention. There is no greek symbol called Vega. If we were using a Greek symbol it would be Kappa.


  14. John Ulschmid
    7 months ago

    Great analysis. How do you play a possible expansion in VOL? a Ratio Backspread?

How To Trade