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.
The guesstimate factor involved in options volatility drives many market observers crazy when they try to understand options prices. In fact, options volatility is such a difficult subject that many traders don't calculate premium. Instead they rely on implied volatility to guide them.
What is the difference between good old volatility and implied volatility? Quite simply, implied volatility is the amount of premium that remains after known quantities, such as carrying cost and intrinsic value, are stripped out of an option's price. Implied volatility is often cited as the market's best guess for the proper level of volatility in a particular option, but that doesn't mean it is the most accurate estimate. So implied volatility is little more than a snapshot of the market at a particular point. This snapshot can be changed by numerous factors. One such factor is heavy institutional trading activity, which is unaffected by the stock's standard deviation. These factors often result in artificially inflated or deflated levels of implied volatility on individual strikes. While confusing, this inherent degree of nuance is what makes options unique. It is also why they are frustrating for traders who expect strict product correlations.
Volatility Skew
The single trading price of a stock is a relatively straightforward concept. However, options have many different strike prices that all perform differently relative to one another. A 15 percent out-of-the-money option is far different than an at-the-money option. This difference impacts the way that volatility premiums are calculated and how options perform in real world conditions.
The phenomenon of different strike prices having different implied volatility levels is known as volatility skew. There are many different types of volatility skew, but the most prevalent skew in equity options is investment skew. Explaining the theoretical underpinnings of investment skew, along with its impact on options pricing, could easily fill this magazine. In short, investment skew occurs because most investors are long the market. This results in lower implied volatility levels on strikes that are above the at-the-money strike and higher implied volatility levels on strikes that are below the at-the-money strike.
There are two main factors driving this disparity in volatility levels. The first is because most investors are happier when the market goes up. The profits on their long positions reduce the levels of uncertainty and fear in the market, resulting in lower volatility levels. The reverse is true as the market drops.
Investors begin to lose money and their level of fear and uncertainty, or volatility, rises.
The second driving factor is more complex. Because investors are primarily long the underlying market, most of their options trades are designed to protect and profit from their long positions. Writing covered calls is the single most popular options strategy. Mutual funds, pension funds, hedge funds and individual investors write millions of calls every day against their long equity positions.
This activity tends to depress the values of call options, resulting in lower implied volatility levels on strikes above the at-the-money strike. Another popular options strategy involves purchasing puts to protect portfolios against downturns in the market.
This buying activity results in higher put options prices, and higher implied volatility levels in strikes below the at-the-money strike.
So Misunderstood
Skew is perhaps the most misunderstood concept in the options world. Many traders don't understand it. This results in countless trading errors and numerous sleepless nights.
I've heard from myriad traders whose call positions lost value despite a rise in the value of the underlying stock.
While skew is difficult to understand, it is merely one of many confusing concepts that make up the intricate subject of options volatility. Although this subject can be intimidating and sometimes frustrating, volatility is also key to understanding the growing world of options.
The views in this column are those of the author and do not necessarily reflect the opinion of Traders Magazine. The columnist can be reached at mark.longo@sourcemedia.com
