What is option volatility ?
Before going deep in discussion with option volatility, I will share my trading position today morning.
You can see, I have constructed a short strangle, ie I have sold out both call and put options.
I am expecting the market will remain within these limits till current month expiry and I will pocket the premium on both sides (16.6+13.45) x 300 = 9015.
But, have you noticed an interesting thing in my positions?. We all know that Market is tend to move in either directions. If this is the case then one of my position should be in green and the other should be in red.
Surprisingly, both of my positions are in red. What does this mean ? Market got inflated in both directions. No, its not possible. Then what made me in loss for both of my positions ? It is option volatility playing the game here. Let’s understand volatility in detail.
As we see in the above screen shot, price of both of the contracts got increased. Option Volatility has a major role in option price calculation.
Volatility is the measurement of how far the fluctuation can happen for a security or Index for a particular period of time.
Let’s understand it with a simple example. I am not going into complicated calculations like standard deviation and all. Consider two stocks “Apollo hospital” and “Page Industries”. See the below comparison chart for both shares for one year.
Here you can notice, the price of Apollo Hospital was continuously in between 0% to 15 %. But the price of page industries has been fluctuating from -30% to 20 %.
It is very clear that PageInd is more volatile than Apollo. But as of today PageInd gives you more return than Apollo.
How can you monetize from the volatility ?
Now you have a fair idea about volatility. We will see how to monetize from volatility.
We know that option price is directly related to volatility. When volatility increases, price of the option contract increases. Even though the underlying has not been changed, the price of option contract has been increased in my example.
In order to monetize from the current situation you need to construct short positions. The idea is simple , price of the option contract will go back to normal once the volatility subsides. So my strategy is, sell today and buy back later at lower price. Here you will earn from the difference in buy and sell premium.
Let’s consider my first example where I had constructed a short strangle. If I had waited till today before entering the position I would have earned more than what I will earn from my current position.
You can check today’s volatility using India VIX here. If the VIX comes down then the volatility has come down in the market. It is not a good time for option sellers because you will collect less premium. But its good time to buy option contracts because you may earn from increase volatility.
Usually the volatility increases with any type of government announcement, election results, RBI policy reviews etc.
Hope this article helped you to understand the term volatility.
Happy reading …