Seven elements determine an option’s cost. Six are well-established, and their input values in an option pricing model are clear. The most crucial element is volatility, which is simply an estimate.

Traders can use various strategies to make money trading volatility. The main methods are listed below.

Essential Notes

1. The predicted future volatility of the actual asset determines the price of an option.

2. Even if various factors determine the price of an option, investors anticipate different degrees of volatility.

3. Options traders can profit from trading volatility, but doing so calls for certain strategies.

4. Using long puts, shorting calls, straddles or binds, ratio writing, and other common volatility trading techniques.

Historical vs. Implied Volatility

Historical or implicit volatility can be stated as a percentage annually. The real volatility the underlying asset has shown over time, like the last month or year, is known as historical volatility (HV). The fundamental volatility of the present option price is implied volatility (IV).

Because implied volatility looks forward, it is more relevant to options pricing than historical volatility. Although implied volatility and historical volatility for a given stock or asset differ, implied volatility can be predicted using historical volatility.

5 Best Volatility Trading Strategies

1. Go Long Puts

Negative investors may purchase puts during periods of extreme volatility, basing their trading strategy on the maxims “buy high, sell higher” and “the trend is your friend.”

For example, on January 27, Company A closed at $91.15. A $90 put, or strike price of $90 on the stock expiring in June, could be purchased by traders who are negative on the stock. On January 29th, this put was offered at $11.40 with an implied volatility of 53%. It would have taken a $12.55 or 14% drop in Company A’s initial values for the put trade to turn a profit.

Traders can purchase an additional out-of-the-money (OTM) put or cover the cost of the long put position if they wish to lower the cost of their position.

2. Short Calls

An adverse trader hoping for a decline in the implied volatility level for the June options would have thought about writing naked calls on Company A at a premium of more than $12. Assuming that on January 29th, the June $90 calls had an offer-ask of $12.35/$12.80, writing these calls would yield a premium of $12.35 or the bid price for the trader.

The trader would have collected the entire premium earned if the stock closed at or below $90 by the call’s June 17 expiration date. The $90 calls would have been worth $5 if the stock had finished at $95 shortly before expiration, leaving the trader’s net gain at $7.35 ($12.35 – $5).

Assume the Vega on the June $90 calls was 0.2216. If the IV of 54% dropped sharply to 40% (14 vols) soon after the short call position was initiated, the option price would have declined by about $3.10 (14 x 0.2216).

3. Short Straddles or Strangles

The trader straddles the market by writing or selling a call and a put at the same strike price to profit from the premiums on both the short-call and short-put positions. By option expiration, the trader expects that IV will have much decreased, allowing them to keep most of the premium they got on their short put and short call bets.

Writing the June $90 call and the June $90 put for Company A would have yielded an option premium of $12.35 + $11.10 = $23.45 for the trader. When the option expired in June, the trader expected the stock to remain near the $90 strike price.

The trader who writes a short put must purchase the substance of the put at the strike price even if it falls.

4. Ratio Writing

When you write a ratio, you write more options than are bought. The most basic method uses a 2:1 ratio, selling or writing two options for each option purchased. The idea is to profit before the option expires from a significant decline in implied volatility.

A trader employed this strategy might have bought a Company Two $100 calls at $8.20 apiece and a write-off or short of the June $90 call at $12.80. In this instance, the net premium received was $3.60 ($8.20 x 2 – $12.80). This approach is comparable to a bull call spread with a short call (June $100 call) and a long call (June $90 call + short June $100 call).

The strategy’s maximum profit is realized if the stock closes at $100 precisely during the option expiration run-up.

5. Iron Condors

By combining a bear call spread and a bull put spread with the same expiration, the trader uses the iron condor method to profit from a decline in volatility that will cause the stock to trade in a narrow range for the duration of the options. Writing a put option at a price other than the current stock price, or spot price, creates an iron condor.

Generally speaking, the calls and puts have equal strike prices equally spaced from the underlying. An iron condor using June option prices from Company A may entail selling the $95 call and purchasing the $100 call for a premium of $1.45 ($10.15 – $8.70) and selling the $85 put and purchasing the $80 put at the same time for a net credit of $1.65 ($8.80 – $7.15). The total credit received is $3.10.

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Frequently Asked Questions

Which seven factors affect an option’s price?

The fundamental asset’s current price, the strike price, the kind of option, the expiration date, the interest rate, the actual option’s dividends, and volatility.

What Distinguishes Implied Volatility from Historical Volatility?

Historical volatility is the real volatility of the underlying asset over time. The fundamental volatility that the present option price implies is implied volatility.

What Is the Iron Condor Strategy’s Primary Objective?

The iron condor makes the most money when the actual asset closes between the intermediate strike prices at expiration. The aim is to profit from the fundamental asset’s low volatility.

Conclusion

Traders employ five ways to profit from highly volatile stocks or securities. The majority of these tactics can be difficult and incur limitless losses. Only seasoned options traders who are knowledgeable about the dangers involved in the game should utilize them.

DISCLAIMER: This information is not considered investment advice or an investment recommendation, but is instead a marketing communication