Is Now a Good Time to Trade Options?
Trading options successfully involves remaining aware of additional pricing factors relevant to options that do not significantly affect the value of the underlying asset itself. These factors include the time to expiration, prevailing interest rates and the implied volatility of the option in question.
To trade options optimally, you therefore need to take your views on those additional factors into account when deciding on the right time to trade options and what strategy to use to encapsulate your market view best. Since market conditions change regularly, read on for more information about making appropriate option trade timing decisions.
Understanding Implied Volatility
A significant factor in the valuation of an option is its implied volatility. Implied volatility can be thought of as a measure of the future risk involved in holding the underlying asset that is anticipated by the market over the option’s lifetime.
Unlike historical volatility, which can be computed as an annualized standard deviation of prices from their average observed over a defined past time period, implied volatility is a market determined quantity that reflects a consensus expectation of future price activity relevant to a particular option series.
Implied volatility can be computed from an option’s market price and other factors involved in calculating option prices using mathematical formulas or models. Common examples are the well-known Black Scholes option pricing model used to evaluate stock options and the Garman Kohlhagen model used for pricing currency options.
Implied volatility only has an impact on an options time value, since its intrinsic value is instead determined by the asset’s market price. Higher implied volatility levels will generally increase an option’s price, while lower levels will decrease an option’s price.
An advantage of implied volatility is that it can be used to price an entire series of options with reasonable accuracy. This greatly simplifies an options market maker’s job, so implied volatility is often quoted among professionals when dealing among themselves and via over the counter (OTC) option brokers.
Changes in implied volatility occur regularly as a result of the key market factors of supply and demand for options of a particular expiration date and strike price. Implied volatility levels can also vary within a series for reasons outlined below.
The Implied Volatility Smile
When looking at the implied volatility of an options series, you might note that if an option’s strike price is very far in the money (ITM) or out of the money (OTM), then its implied volatility will tend to be higher than that of at the money (ATM) options of the same expiration date.
This so-called implied volatility “smile” arises because the theoretical time value of such ITM or OTM options can be rather small and even approach zero, but yet the risk of selling them can remain significant in case of a substantial market move. Prudent option market makers will therefore often refuse to sell such options below a certain non-zero minimum time value, while bidding very little, if any, time value for them.
This phenomenon can cause the average of the bid and offered implied volatility levels of options to rise as the options becomes substantially farther ITM or OTM relative to ATM options of the same series. The result is the smile shaped implied volatility curve typically seen among options of a particular expiration date or series on a given asset.
It would be an error to mistake this smile curve for a sign that those ITM or OTM options are expensive and should therefore be sold. They are intentionally priced at higher average implied volatility levels for a very good reason.
The Implied Volatility Skew
Another common situation that can cause implied volatility levels within an option series to differ is the existence of a prevailing trend in the underlying asset market. This situation can cause a supply and demand effect whereby the option strike prices in the direction of the trend have higher implied volatility levels than those away from the direction of the trend.
Known as the implied volatility “skew,” this can result in OTM calls and ITM puts being priced at implied volatility levels significantly above that of OTM puts and ITM calls when the stock has been rising regularly of late.
Alternatively, should serious concerns arise among market participants that a stock will soon be reversing its upward direction to begin a sharp downwards correction, then the OTM puts/ITM calls on that stock might start to trade at an implied volatility premium to OTM calls/ITM puts.
The observed strength of this implied volatility skew can act as an indicator of the expectations option market makers and their clients have for the prevailing trend in the underlying asset to persist or reverse itself.
How Implied Volatility Impacts Option Trading Decisions
When it comes to trading options, if you think current levels of implied volatility are low in comparison to the sort of price fluctuations you expect will occur over the option’s lifetime, then you can net buy those options to go long volatility aiming to profit from a rise in implied volatility. If you think they are high, then you can net sell those options to go short volatility.
Vertical spreads involve buying and selling options of the same expiration date. They reduce your exposure to implied volatility when using options to take a market view.
Horizontal or calendar spreads involve buying and selling options of different expiration dates, so they reduce your overall implied volatility exposure too. You can also use them to take a view on how the curve of implied volatility versus time to expiration will steepen or flatten.
Keep in mind that an option’s value will naturally decline over time due to time decay. If you go long options, your position will experience a daily decline in value if all other factors remain equal. Conversely, if you go net short options, your position will rise in value if other pricing factors stay constant.
The time decay options normally experience can therefore complicate the process of using options alone to speculate on implied volatility. A cleaner bet on implied volatility can sometimes be made using implied volatility futures. An example is the Cboe Volatility Index (VX) Futures or VIX futures contract traded on the Chicago Board Options Exchange that reflects the implied volatility of options on the Standard and Poor’s 500 stock index.
When Options Offer Good Value
Buying options tends to offer good value as an alternative to taking a position in the underlying asset when you expect the market will heat up in the near future. Since an option’s risk is limited to the premium you pay, you therefore have less risk than just holding the asset itself.
If your view on the underlying market turns out to be correct, then taking a long option position can result in an added boost to your trade’s profitability since implied volatility should also rise if the market enters into very risky trading conditions characterized by wild price swings.
Those holding the asset in such circumstances might hedge their long position by buying put options. Also, holding an option probably seems preferable to traders versus holding a position in the underlying asset since their risk is limited to the premium paid for the option.
The downside risk of holding an option is fully limited to the premium you paid for it. In contrast, the risk of holding an asset is only limited at the point the asset — and hence your entire investment in it — becomes absolutely worthless.
This risky situation will typically increase the market price of options for the impacted series as demand for them rises. This will also boost the implied volatility of those options.
An example of when options offer good value would be when you expect a sudden decline in the stock market after a consolidation period. The consolidation might result in a decline in implied volatility, which could make options seem cheap to you.
A subsequent sharp stock market drop will also often cause substantial put option buying interest to emerge as traders and investors move to hedge the long holdings in their stock portfolios. This then drives affected option prices higher, along with their implied volatilities.
When Options Seem Overvalued
You might sometimes observe that the market is currently expecting to see more active price action over a future time period than you anticipate. This could make options seem overvalued to you. Some possible option strategies you could use to take advantage of this view appear below:
- Sell naked put: If you have a bullish view on the underlying, but a bearish view on implied volatility.
- Sell covered put: You could sell a put against a short position in the underlying asset if you wish to profit from a period of price stability or buffer it against modest rises.
- Sell naked call: If you have a bearish view on the underlying and on implied volatility.
- Sell covered call: If you are long the underlying asset and wish to get income from a period of stability in its price or buffer your position against losses from a slightly declining market.
- Sell straddles or strangles: If you had a neutral view on the underlying asset, you could do this to profit from a bearish view on implied volatility. The short ATM straddle position consists of a sold ATM put and a sold ATM call in equal amounts, while establishing a short OTM strangle position could involve selling equally OTM put and call options.
Keep in mind that selling options, either naked or covered, involves taking considerable risk. Make sure you are prepared to take that risk, leverage the benefits of a top options broker, and have adequately planned your exit strategy in case the market unexpectedly goes against you.