Option Trading Strategies to Profit from Volatility in Markets

Option trading is very popular with traders and there is a reason for it. The possibility of making huge gains with little capital and in quick time is what makes it attractive. Also, the sheer varieties of strategies that can be used in different market conditions draw the attention of the masters of the stock market to option trading. Shreya Chaware discusses at length the top option strategies that can be used by a trader in the current volatile markets. 



As frontline indices and broader markets grab headlines after hitting their all-time highs, several investors and traders are concerned that the current rally may not be sustainable and that the volatility may show its ugly head in the coming weeks. Volatility may be a concern for several investors and traders who are used to trade long and invest for short-term by taking leverage positions; however, increase in volatility is a great boon for option traders who know how to trade volatility profitably. India VIX is at its lowest point in 2021 and the S & P 500 VIX is down by more than 56 per cent in one year. 

With the markets at an all-time high and the VIX levels extremely low, one has to be cautious about the possibility of change in market direction in the short term. A pull-back in the markets can create a window of opportunity for those who are willing to enter the markets for long term but it will kill returns for those traders who have positioned themselves for the markets to hit fresh highs in the near term. The only player who will be protected either way will be the option trader who knows how to trade volatility and profit from it by creating a delta neutral strategy. 

Delta Neutral Strategy
A delta neutral strategy is designed to create positions that aren’t likely to be impacted by small movements in the price of the underlying. This can be achieved if the overall delta value of a position is closer to zero. Delta measures how much an option’s price changes when the underlying security’s price changes. Option delta helps us correlate the change in the price of option for change in the underlying security. For example, an option with delta value of 1 will increase in price by Rs 1 for every Rs 1 increase in the price of the underlying security. It also decreases by Rs 1 for every Rs 1 decrease in the price of the underlying.

A delta value ranges from 0 to 1 for call options and from 0 to –1 for put options. It is important to remember that the delta value is theoretical rather than an exact science; however, the corresponding price movements are relatively accurate in practice. Delta neutral strategies are used to either profit from time decay or from volatility. For traders the goal is to achieve a delta neutral strategy with as low capital as possible, which can be done after combining the delta values of options or stocks. For example, if you owned 10 calls with a delta value of 1, the overall delta value of your position would be 100. For every Rs 1 increase in the price of the underlying security the total price of a trader’s options would increase by Rs 100. 

"Amateur traders are obsessed with making money while professional traders are obsessed with managing risks."

It is worth noting that the delta values of call writing are reverse to that of call options. This essentially means that when you write 10 calls with a delta value of 1, the delta value of total position is negative 10. When a trader achieves an overall delta value of a position closer to 0 the trader has achieved a delta neutral position. For example, if a trader owns 200 puts with a delta value of –0.5 and owns 100 shares of the underlying stock – the total value 100 as stock has a delta of 1 – then it is a delta neutral position. It is important to note that the delta value of an option position can change as the price of an underlying security changes. Thus, a delta neutral position won’t necessarily remain neutral if the price of the underlying security moves sharply.

Profiting from Time Decay
When you own option i.e. buy an option, the effects of time decay are negative as extrinsic value decreases when we move closer to the expiration date. This is exactly where the option sellers attempt to make profits. An option seller will gain from the time decay as we move towards the expiration date. Hence, it makes sense to create a delta neutral strategy where you can benefit from the effects of time decay and not lose any money from small price movements in the underlying security. One of the most popular ways to create such a delta neutral position that can profit from time decay is to write at-themoney calls and write an equal number of at-the-money put options for the same underlying. Here, in this strategy one can lose loads of money if the stock moves farther in one direction from the strike price in any direction. One can still make money in this strategy if the stock prices moves within a limited range from the strike price. One can always close the positions if it is felt that the stock is moving uni-directionally too far from the strike price to make the trade unprofitable.

Profiting from Volatility
Volatility and option pricing are intertwined. Volatility is one of the most important factors to consider while trading in options as the option prices are directly impacted by volatility. If you expect volatility to increase substantially one of the best ways to profit from it is by buying call options and put options of similar strike prices, which are essentially at-the-money. This strategy involves some initial investment and may go worthless if the stock prices settle near the strike price. However, the trader stands to gain if the stock prices move farther from the strike price. This happens when the volatility increases sharply.

Volatility in option trading is measured by implied volatility. Implied volatility analysis is very important for booking profit while trading in options. It is frequently observed that options become way too expensive or way too cheap at times. Those tracking options and their implied volatility can sense an opportunity here and attempt to make some quick profit purely by trading on volatility. Traders can always count on volatility returning to normal levels after going to an extreme which is called ‘the mean reversion tendency of volatility’. It is observed that whenever volatility goes to the extreme level it comes back to normal. Option traders using implied volatility to enter and exit trades can bank on this ‘mean revert’ tendency of volatility.

Implied volatility changes on a weekly basis if not on a daily basis. The option traders can depict the movement in implied volatility to profit from it rather than be scared of it. It is the level of implied volatility that actually tells us if the options are cheap or expensive. In simple words, high implied volatility options are expensive while low implied volatility options are considered inexpensive. Whenever the IV is high and the corresponding historical volatility of the underlying asset is not as high, option traders have an opportunity to make some quick money by selling option. Eventually when the volatility dries up, the option premium comes down and the trader can book profits.

Conclusion
There are times when the markets are volatile and again there are times when the markets are extremely volatile. A true option trader is able to understand the exact difference here and is able to consistently hunt for profitable opportunities based simply on the heightened volatility. Implied volatility or IV, as it is popularly known, is the tool that is smartly exploited by a seasoned option trader to trade volatility. The trick is to sell options when the premium is extremely expensive or overvalued. The option premium is expensive or overvalued when the volatility shoots up. Hence, smart option traders have to buy options when the implied volatility is low and book profits when the implied volatility is peaking.

If one is comfortable selling options then a trader can sell options when the volatility has peaked and buy back the same option when volatility has subsided, thus booking profits in the process. It is not as simple as it sounds. However, tracking IV movement and observing the option price movement and correlating with volatility will help traders book identify hidden opportunities in the market. In present times, Nifty is at its all-time high and there will be bouts of profit-taking in the markets in the coming weeks. The volatility is expected to increase manifold in the markets and the option traders can take full advantage of the extreme volatility, usually expected when the markets attempt to take a breather at all-time highs.