Let's Talk About Vol
There’s a lot of talk about volatility in the financial world these days. In fact, it seems like the Chicago Board Option Exchange’s Volatility Index (VIX) has become the bellwether of choice 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 looming correction in the broad market.
This discussion has raised questions about the role that volatility plays in the options markets. There is also some confusion about how volatility premiums are determined and what options pros actually mean when they use the term volatility. While explaining all of the intricacies of this topic would fill this entire site several times over, we can peel back the curtain a bit to shed some light on the bizarre world of volatility in the options markets.
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 measures the 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 undoubtedly the king of the bunch. A handful of options traders choose to focus on short-term directional speculation or collecting time decay, but the real money is made and lost on volatility. In fact, many professional options traders refer to themselves simply as volatility traders, since it more accurately represents their product and trading style.
HAIL TO THE KING
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 all of these factors together, something was still missing from the option’s price. There was a ghost in the machine, and its name was vega.
FUDGING THE NUMBERS
The pivotal role that volatility plays in options pricing is what makes these markets so fascinating for trading and speculation. It is also what makes options markets so intimidating and dangerous to the uninitiated. Even with the exact 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 relentless increases in bandwidth and processing power, has allowed for a greater degree of sophistication in this process. 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 mystical subject that many traders give up trying to calculate premium and instead 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 is left over 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. At the end of the day, implied volatility is little more than a snapshot of the market at a particular moment in time. This snapshot can be impacted by a number of factors, such as heavy institutional trading activity, that have nothing to do with the standard deviation of the stock. 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 so unique. It is also what makes them so frustrating for traders who expect strict correlations in their products.
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