Seven factors determine the price of an option. Six have known values, and there is no ambiguity about their effects in an 澳洲幸运5开奖号码历史查询:option pricing model. The seventh variable, volat🍨ility, is only an estimate - and yet, it is the most important factor in determining an option’s price.

There are various strategies traders use to generate returns when tradin🥂g volatility. Below, we discuss some of the more popular ones.

Factors That Determine the Price of an Option

There are seven factoꦦrs that determine the price of an option. The vo🎃latility is the only factor that is unknown, which allows traders to bet on volatility spikes or drops.

• The current price of the underlying asset - known
• Strike price - known
• Type of option (Call or Put) - known
• Time to the expiration of the option - known
• Risk-free interest rate - known
• Dividends on the underlying - known
• Volatility - unknown
  

Historical vs. Implied Volatility

Volatility can be historical or implied, expressed on an annualized basis in percentage terms. 澳洲幸运5开奖号码历史查询:Historical volatility (HV) is the actual volatility demonstrated by the underlying asset over a prior time period, such as the past month or year. 澳洲幸运5开奖号码历史查询:Implied volatility (IV) is the level of ꦚvolatility of the underlying implied by the current o🐬ption price.

Implied volatility is more relevant than historical ꧂volatility for options’ pricing because it looks forward. While historical and implied volatility differ, h♋istorical volatility can be a determinant of implied volatility.

An elevated level of implied 澳洲幸运5开奖号码历史查询:volatility☂ will result in a hig💝her option price, and a depressed level of implied volatility will result in a lower option price. Volatility typically spikes around the time a company reports earnings. Thus, the implied volatility priced in around “澳洲幸运5开奖号码历史查询:earnings season” will g𓄧enerally be significantly higher than volatility estim𝓀ates during regular times.

Volatility and Vega

The “Option Greek” that measures an option’s price sensitivity to implied volatility is known as Vega. Vega expresses෴ the price change of an option🍎 for every 1% change in volatility of the underlying asset.

• Relative volatility is the volatility of the stock at present compared to its volatility over some time. Suppose stock A’s at-the-money options expiring in one month have generally had an implied volatility of 10%, but are now showing an IV of 20%, while stock B’s one-month at-the-money options have historically had an IV of 30%, which has now risen to 35%. On a relative basis, although stock B has greater absolute volatility, it is apparent that A has had a bigger change in relative volatility.
• The overall level of volatility in the broad market is also an important consideration when evaluating an individual stock’s volatility. The best-known measure of market volatility is the 澳洲幸运5开奖号码历史查询:Cboe Volatility Index (VIX), which measures the volatility of the S&P 500. Also known as the fear gauge, the VIX tends to have sharp spikes when the S&P 500 moves significantly lower, and, conversely, the VIX generally trades lower when the S&P 500 is on a steady rise.

Option traders typically sell, or write, options when implied volatility is high because this means selling or “going short” on volatility, betting that it will 澳洲幸运5开奖号码历史查询:revert to the mean. Likewise, when implied volatility is low, options traders will buy options or “go long” on volatility, anticipating a rise༒ꩵ.

1. Go Long Puts

When volatility is high, traders who are bearish on the stock may buy puts based on the twin premises of “buy high, sell higher,” and “the trend is your𓂃 friend.”

For example, Company A clos❀ed at $91.15 on Jan. 27th. Bearish traders could buy a $90 put, or of $90, expiring in June. The implied volatility of this put was 53% on Jan. 27th, and it was offered at $11.40. Company A would have had to decline by $12.55 ($1.15 to the $90 strike level + $11.40 paid for the option) or 14% from starting levels before the put position is pr✃ofitable.

Traders who want to reduce the cost of their long put position can buy a further 澳洲幸运5开奖号码历史查询:out-of-the-money (OTM) put, or offset the cost of the long put by adding a short put position at a lower price - a strategy known as a bear put spread. A trader could have bought a June $80 put at $7.15, which was $4.25 or 37% cheaper than the $90 put at the time, or entered a 澳洲幸运5开奖号码历史查询:bear put spread by buying the $90 put at $11.40 and selling (writing) the $80 p🤡ut at $6.75. As such, the net cost of the bear put would be $4.65, far lower꧑ than the $11.40 in the long put scenario, although the profit potential is also more limited.

2. Short Calls

A trader who is bearish on the stock but hopeful the level of implied volatility for the June options could recede, may consider writing 澳洲幸运5开奖号码历史查询:naked calls on Company A for a premium of over $12. Assume that the June $90 calls had a bid-ask 🐬of $12.35/$12.80 on Jan. 29th, so writing these calls would result in the trader receiving a premium of $12.35 by selling at the bid price.

If the💧 stock closed at or below $90 by the June 17 expiration, the trader would have kept the full amount of the premium received. If the stock closed at $95 just before expiration, the $90 calls would have been worth $5, so the trader’s net gain would still be $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 decli🦂ned by about $3.10 (14 x 0.2216).

Writing or shorting a naked call is a risky strategy, because of the unlimited risk if the underlying stock or asset surges in price. What if Company A soared to $150 before the June expiration of the $90 naked call position? In that case, the $90 call would have been worth at least $60, and the trader would be looking at a staggering 385% loss. To mitigate this risk, traders often combine the short call position with a long call position at a higher price in a strategy known as a bear call spread.

3. Short Straddles or Strangles

In a straddle, the trader writes or sells a call and a put at the same strike price to receive the premiums on both the short call and short put positions. The trader expects IV to abate significantly 🌌by option expiry, allowing most of the 💙premium received on the short put and short call positions to be retained.

For Company A, writing the June $90 call and writing the June $90 put would have resulted in the trader receiving an option premium of $12.35 + $11.10 = $23.45. The trader bets on the stock staying close to the $90 strike price by the June expiration.

Writing a short put requires the trader to buy the underlying at the strike price even if it plunges to zero while writing a short call has unlimited risk. However, the trader has some margin of safetꦯy due to the significant premium received.

If the underlying Company A stock closed above $66.55 (strike price of $90 - premium received of $23.45) or below $113.45 ($90 + $23.45) by option expiry in June, the strategy would have been profitable. The exact profitability depends on where the stock price was by option expiry; profitability was maximized at a stock price by expiration of $90 and reduced as the stock gets further away from the $90 level.

If the stock closed below $66.55 or above $113.45 by option expiry, the strategy would have been unprofitable. Thus, $66.55 and $113.45 were the two breakeven points for this short straddle strategy.

A short strangle is similar to a short straddle, but the strike pric꧂es on the short put and short call are not the same. The call strike is above the put strike, and both are out-of-the-money and approximately equidistant from the current price of the underlying.

With Company A trading at $91.15, the trader could have written a June $80 put at $6.75 and a June $100 call at $8.20, to receive a net premium of $14.95 ($6.75 + $8.20). In return for receiving a lower level of premium, the trader also receives lower risk due to wider breakeven points of $65.05 ($80 - $14.95) and $114.95 ($100 + $14.95). 

4. Ratio Writing

澳洲幸运5开奖号码历史查询:Ratio writing means writing more options than are purchased. The simplest strategy uses a 2:1 ratio, with two opꦓtions, sold or written for every option purchased. The rationale is to capitalize on a substantial fall in implied volatility before option expiration.

A trader using this strategy could have purchased a Company A June $90 call at $12.80 and written or shorted two $100 calls at $8.20 each. The net premium received in this case was $3.60 ($8.20 x 2 - $12.80). This strategy is equivalent to a 澳洲幸运5开奖号码历史查询:bull call spread (long June $90 call + short June $100 call) with💯 a short call (June $10🅠0 call).

The maximum gain from this strategy accrues if the underlying stock closed exactly at $100 shortly before option expiration. In this case, the $90 long call would have been worth $10, while the two $100 short calls would expire worthlessly. The maximum gain would be $10 + premium received of $3.60 = $13.60.

Ratio Writing Benefits and Risks

What if the stock closed at $95 by option expiry? In this case, the $90 long call would have been worth $5, and the two $100 short calls would expire worthless. The total gain would have been $8.60 ($5 + net premium received of $3.60). If the stock closed at $90 or below by option expiry, all three calls expire worthless, and the only gain would have been the net premium received of $3.60.

What if the stock closed above $100 by option expiry? In this case, the gain on the $90 long call would have been eroded by the loss on the two short $100 calls. At a stock price of $105, for example, the overall P/L would have been: $15 - (2 X $5) + $3.60 = $8.60

The breakeven for this strategy would be at a stock price of $113.60 by option expiry, at which point the P/L would be: (profit on long $90 call + $3.60 net premium received) - (loss on two short $100 calls) = ($23.60 + $3.60) - (2 X 13.60) = 0. The strategy is increasingly unprofitable if the stock rises above the break-even point of $11ܫ3.60.

5. Iron Condors

In an 澳洲幸运5开奖号码历史查询:iron condor strategy, the trader combines a bear call spread with a 澳洲幸运5开奖号码历史查询:bull put spread of the same expiration to capitalize on a retreat in volatility that will result in the stock trading in a narrow range during the life of the options. Generally, the difference between the str𓂃ike prices of the calls and puts is the same, and theꦐy are equidistant from the underlying. Using Company A's June option prices, an iron condor might involve selling the $95 call and buying the $100 call for a premium received of $1.45 ($10.15 - $8.70) and simultaneously selling the $85 put and buying the $80 put for a net credit of $1.65 ($8.80 - $7.15). The total credit received is $3.10.

Generally, the difference between the strike prices of the calls and puts is the same, and they are equidistant from the underlying. Using Company A's June option prices, an iron condor might involve selling the $95 call and buying the $100 call for a premium received of $1.45 ($10.15 - $8.70) and simultaneously selling the $85 put and buying the $80 put for a net credit of $1.65 ($8.80 - $7.15). The total credit received is $3.10.

The maximum gain from this strategy was equal to the net premium received ($3.10), which would accrue if the stock closed between ⭕$85 and $95 by option expiry. The maximum loss occurs if the stock at expiration trades above the $100 call strike or below the $80 put strike. The maximum loss would equal the difference in the strike prices of the calls or puts, respectively, less the net premium received, or $1.90 ($5 -🥃 $3.10). The iron condor has a relatively low payoff, and loss is limited.

The Bottom Line

The five strategies discussed are among the more commonly used techniques for trading volatility with options. However, they come with inherent complexities and risks, including potentially 澳洲幸运5开奖号码历史查询:unlimited losses. These strategies should only be executed by experienced traders who fully understand the൩ nuances of options trading and are prepared to manage the suꦜbstantial risks.