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August 9, 2006

The Greeks & Volatility: Determining an option's risk premium is an inexact science

By Mark Longo

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  • The Greeks & Volatility: Determining an option's risk premium is an inexact science

There's a lot of talk about volatility in the financial world these days. In fact, it seems like the Chicago Board Options Exchange's Volatility Index (VIX) has become the bellwether for market sentiment. The VIX, which measures the front month volatility of S&P 500 index options, has hovered near historic lows for years despite an explosion of volume in the options markets. However, the VIX has nearly doubled in recent months, prompting fears of a correction in the broad market.

This discussion has raised questions about the role that volatility plays in the options markets. Among equity traders, there is also some confusion about how volatility premiums are determined and what options pros mean when they use the term volatility. Explaining this entire topic is beyond the scope of this column, but we can raise the curtain a bit to shed some light on the complex world of options markets volatility.

The Kings of the Greeks

There are four variables that traders use to measure their risk exposure in the options markets-delta, gamma, theta and vega. Delta measures a position's directional risk. Gamma explains changes in that directional risk as the underlying moves. Theta approximates how much value options lose as they approach expiration. And vega measures a position's exposure to volatility. These four variables are collectively known as "the Greeks." While all four Greeks are important, vega is paramount. A handful of options traders choose to focus on short-term directional speculation or collecting time decay. But the most money is made and lost on volatility. In fact, many professional options traders refer to themselves as volatility traders. This more accurately explains their product and trading style.

What is this thing called vega? How does it turn paupers into princes and tame the mightiest of institutions? In layman's terms, vega is little more than a hunch. The earliest options pricing models struggled to account for this powerful yet ethereal mover of markets.

These models could easily factor in things like interest rates and carrying costs. Even calculating an option's intrinsic value was child's play. However, when one lumped these factors together, something was still missing from the option's price. There was a ghost in the machine. Its name was vega.

The pivotal role that volatility plays in options pricing is why these markets are so fascinating for trading and speculation. It is also what makes options markets so intimidating to the uninitiated. Even with the same data at their disposal, two options traders can come up with wildly different estimates of the proper amount of volatility premium.

The move to electronic trading in recent years, along with increases in bandwidth and processing power, has led to a greater degree of sophistication in this process.

Educated Guesses

However, even the most intricate computer models generate results that are often little better than educated guesses. At the end of the day, determining the proper amount of volatility premium remains a dark art that is half computation and half experience, with a little bit of blind luck thrown into the mix.