- 1998: Volume 7, No. 5 Using Volatility To Select The Best Option Trading Strategy

Option trading is a game of probability. One of the best ways to put the odds on your side is to pay close attention to volatility and to use that information in selecting the proper trading strategy. There are many different option trading strategies to choose from. In fact, one of the primary advantages to trading options is that you can craft positions for any market outlook—up a little, down a little, up a lot, down a lot, or even unchanged over a period of time. This offers traders more flexibility than simply being long or short a stock.

One important key to option trading success is to know whether a rise or fall in volatility will help or hurt your position. Some strategies should only be used when volatility is low, others only when volatility is high. It is important to first understand what volatility is and how to measure whether it is presently high or low or somewhere in between, and second to identify the proper strategy to use given the current level of volatility.

Is Volatility High or Low?

Before proceeding, lets first define some terms and explain what we mean when we talk about volatility and how to measure it.

The price of any option is comprised of "intrinsic" value if it is "in-the-money," and "time premium." A call option is in-the-money if the option's strike price is below the price of the underlying stock. A put option is in-the-money if the option's strike price is above the price of the underlying stock. Time premium is some amount above and beyond any intrinsic value and essentially represents the amount paid to the writer of the option in order to induce him to assume the risk of writing the option. Out-of-the-money options have no intrinsic value and are comprised solely of time premium. The level of time premium in the price of an option is a critical factor and is influenced primarily by the current level of volatility. In other words, generally speaking, the higher the volatility level for a given stock or futures market, the more time premium there will be in the prices for the options of that stock or futures market. Conversely, the lower the volatility the lower the time premium. Thus if you are buying options, ideally you would like to do so when volatility is low which will result in paying relatively less for an option than if volatility were high. Conversely, if you are writing options you will generally want to do so when volatility is high in order maximize the amount of time premium you receive.

Implied Volatility Defined

The "implied volatility" value for a given option is the value that one would need to plug into an option pricing model (such as the famous Black/Scholes model) to generate the current market price of an option given that the other variables (underlying price, days to expiration, interest rates and the difference between the option's strike price and the price of the underlying security) are known. In other words, it is the volatility "implied" by the current market price for a given option. There are several variables which get entered into an option pricing model to arrive at the implied volatility of a given option:

1. The current price of the underlying security
2. The strike price of the option under analysis
3. Current interest rates
4. The number of days until the option expires
5. The actual price of the option

Elements A, B, C and D and E are "known" variables. In other words, at a given point in time one can readily observe the underlying price, the strike price for the option in question, the current level of interest rates and the number of days until the option expires and the actual market price of the option. To calculate the implied volatility of a given option we pass elements A through E to the option model and allow the option pricing model to solve for element F, the volatility value. A computer is needed to make this calculation. This volatility value is called the "implied volatility" for that option. In other words, it is the volatility which is implied by the marketplace based on the actual price of the option. For example, on 8/18/98 the IBM September 1998 130 Call option was trading at a price of 4.62. The known variables are:

1. The current price of the underlying security = 128.94
2. The strike price of the option under analysis = 130
3. Current interest rates = 5
4. The number of days until the option expires = 31
5. The actual market price of the option = 4.62
6. Volatility = ?

The unknown variable which must be solved for is element F, volatility. Given the variables listed above, a volatility of 32.04 must be plugged into element F in order for the option pricing model to generate a theoretical price which equals the actual market price of 4.62 (this value of 32.04 can only be calculated by passing the other variables into an option pricing model). Thus, the "implied volatility" for the IBM September 1998 130 Call is 32.04 as of the close on 8/18/98.

Implied Volatility For a Given Security

While each option for a given stock or futures market may trade at its own implied volatility level, it is possible to objectively arrive at a single value to refer to as the average implied volatility value for the options of a given security for a specific day. This daily value can then be compared to the historical range of implied volatility values for that security to determine if this current reading is "high" or "low." The preferred method is to calculate the average implied volatility of the at-the-money call and put for the nearest expiration month which has at least two weeks until expiration, and refer to that as the implied volatility for that market. For example, if on September 1, IBM is trading at 130 and the implied volatility for the Sep 130 Call and Sep 130 Put are 34.3 and 31.7, respectively, then one can objectively state that IBM's implied volatility equals 33 ((34.3 + 31.7) / 2).

The Concept of Relative Volatility

The concept of Relative Volatility ranking allows traders to objectively determine whether the current implied volatility for the options of a given stock or commodity is "high" or "low" on a historical basis. This knowledge is key in determining the best trading strategies to employ for a given security. A simple method for calculating Relative Volatility is to note the highest and lowest readings in implied volatility for a given securities' options over the last two years. The difference between the highest and lowest recorded values can then be cut into 10 increments, or deciles. If the current implied volatility is in the lowest decile, then Relative Volatility is "1." If the current implied volatility is in the highest decile then Relative Volatility is "10." This approach allows traders to make an objective determination as to whether implied option volatility is currently high or low for a given security. The trader can then use this knowledge to decide which trading strategy to employ.

Figure 1 Low Volatility Cisco Systems

Figure 2 High Volatility Bristol-Myer

As you can see in Figures 1 and 2, the implied volatility for each security can fluctuate widely over a period of time. In Figure 1 we see that the current implied volatility for Cisco Systems is about 36 and in Figure 2 we see that the implied volatility for Bristol Myers is about 33. Based on raw values, these implied volatilities are roughly the same. However, as you can see the volatility for Cisco Systems is on the low end of its own historical range while the implied volatility for Bristol Myers is very close to the high end of its own historical range. The savvy options trader will recognize this fact and will use different trading strategies for trading options on these two stocks (see Figures 4 and 5).

Figure 3 shows a daily ranking of current implied volatility levels for some stocks and futures markets. As you can see the raw level of implied volatility can vary greatly. However, by comparing the raw value for each stock or futures market with the historical range of volatility for that given stock or futures market, one can arrive at a Relative Volatility Rank between 1 and 10. Once the Relative Volatility Rank for a given stock or futures market is established a trader can then proceed to Figures 4 and 5 to identify which strategies are appropriate to use at the present time, and just as importantly, which strategies to avoid.

Figure 3

Source: Option Pro by Essex Trading Co., Ltd.

Figure 4

Relative Volatility/Trading Strategy Reference Table Relative Volatility Rank (1-10)
Strategy	Profit Potential	Risk	1	2	3	4	5	6	7	8	9	10
Buy Straddles	Unlimited	Limited	X	X
Calendar Spreads	Limited	Limited	X	X
Buy Naked Options	Unlimited	Limited	X	X	X
Backspreads	Unlimited	Limited	X	X	X	X	X
Buy Verticals	Limited	Limited	X	X	X	X	X
Sell Verticles	Limited	Limited						X	X	X	X	X
Sell Double Verticals	Limited	Limited							X	X	X	X
Buy Ratio Spreads	Limited	Unlimited								X	X	X
Sell Naked	Limited	Unlimited									X	X
Sell Straddles	Limited	Unlimited									X	X
Source: Option Pro by Essex Trading Co., Ltd.

Figure 5

Relative Volatility Rank (1-10)
Strategy	Profit Potential	Risk	1	2	3	4	5	6	7	8	9	10
Buy Underlying/ Buy Put	Unlimited	Limited	X	X	X
Short Underlying/ Buy Call	Limited	Limited	X	X	X
Buy Underlying/ Sell Call/Buy Put	Limited	Limited				X	X	X	X
Short Underlying/ Sell Put/Buy Call	Limited	Limited				X	X	X	X
Buy Underlying/ Sell Call	Limited	Unlimited								X	X	X
Short Underlying/ Sell Put	Limited	Unlimited								X	X	X
Source: Option Pro by Essex Trading Co., Ltd.

Considerations in Selecting Option Trading Strategies

Current Implied Volatility and Relative Volatility Rank—If Relative Volatility (on a scale of 1 to 10) is low for a given security, traders should focus on buy premium strategies and should avoid writing options. Conversely, when Relative Volatility is high, traders should focus on sell premium strategies and should avoid buying options.

This simple filtering method is a critical first step in making money in options in the long run. The best way to find the "good" trades is to first filter out the "bad" trades. Buying premium when volatility is high and selling premium when volatility is low are "low probability" trades, as they put the odds immediately against you. Avoiding these low probability trades allows you to focus on trades which have a much greater probability of making money. Proper trade selection is the most important factor in trading options profitably in the long run.

As you can see in the implied volatility graphs displayed in Figures 1 and 2, implied option volatility can fluctuate widely over time. Traders who are unaware of whether option volatility is currently high or low have no idea if they are paying too much for the options they are buying, or receiving too little for the options that they are writing. This critical lack of knowledge costs losing option traders countless dollars in the long run.

David Wesolowicz and Jay Kaeppel are the co-developers of Option Pro trading software. Mr. Wesolowicz is the President of Essex Trading Company and was a floor trader at the Chicago Board Options Exchange for nine years. Mr. Kaeppel is the Director Of Research at Essex Trading Co. and is the author of The PROVEST Option Trading Method and The Four Biggest Mistakes in Option Trading. Essex Trading Company is located at 107 North Hale, Suite 206, Wheaton, IL 60187. They can be reached by phone at 800-726-2140 or 630-682-5780, by fax at 630-682-8065, or by e-mail at essextr@aol.com. You can also visit their web site, www.essextrading.com