Adjusting for volatility

Options are among the most unique financial trading instruments available to everyday traders around the world. Options have been used for centuries in all walks of life. Aristotle wrote about buying an option to use olive presses during harvest, real estate developers may use options to assemble large tracts of land, film producers buy option rights on books and screenplays and in our great American pastime, baseball, players and teams negotiate options on contracts.

Here we are talking about the financial instruments traded as call and put option contracts. An option is the right, but not the obligation, to buy or sell a specific quantity of the underlying instrument at an agreed price on a specified date. Options pricing is three dimensional, based on the underlying asset’s price, time to expiration and implied volatility. Although each of these dynamic factors influences the daily price changes of an option; volatility change may be the most influential for several reasons, which we’ll discuss in detail. When trading options, volatility should weigh heavily on your decisions to trade certain strategies.


Before we discuss the detail of why volatility is so important, let’s define what we mean by volatility itself. When we refer to volatility, we are really referring to the Chicago Board Options Exchange (CBOE) Volatility Index (ticker symbol: VIX). The VIX shows the market’s 30-day volatility expectation of the S&P 500. It is often referred to as an “investor fear gauge” because as the market rallies, the VIX tends to decrease showing a lack of fear in the marketplace. However, if the market drops dramatically or day-to-day-trading ranges begin to increase, the VIX spikes upward reflecting an increase in fear (see “Fear gauge,” below).

Volatility is directly related to vega, one of the option “Greeks” or variables that measures different risk dimensions. Vega measures an option’s sensitivity to volatility and is measured as the rate of change of an option’s intrinsic value and the underlying asset’s volatility. For example, if the vega of an option is 50 and volatility were to rise by 1%, then the option’s value would theoretically increase by $0.50 with no change in the underlying. In effect, vega measures your option portfolio’s dynamic risk profile as the underlying asset (S&P 500) and the VIX increase or decrease. Theoretically, if an entire portfolio of options had a vega value of 5000 and VIX increased by 1% due to the market moving 10 points lower, then the value of the portfolio would in effect gain $5000.


Volatility changes can affect certain trading strategies in different ways. Given the recent sloppy markets, we are going to display what happens during a spike in volatility, such as the May-June volatility spike. Now that we have some background for both volatility and vega, we can look to a concrete example of what happens to an option’s price throughout a trading cycle. The general theory says that as VIX increases, option premiums increase. Hence, the owner of an option will profit as the VIX increases because premiums increase. The opposite is also true: as the VIX decreases, the seller of an option will profit because of the decrease in the VIX as premiums decrease in tandem with the VIX. So what about the spread trader who is long and short options? Let’s take a look.

The example below is called a “Calendar Condor,” because of the shape of the P/L curve: it is a derivation of a calendar spread and an iron condor. We would sell the front month option closer to the money while purchasing the further out of the money deferred month option as our hedge. A calendar condor begins as a net debit spread because the longs will cost more than the short positions. However, through time as you continue to roll the short positions into your longs, the spread becomes a net credit spread. This particular trade was placed on May 8, 2006 (see “From debit to credit,” below). At the time, the VIX was chugging along between 10% and 12% just before the market dropped precipitously to 52-week lows and the VIX spiked into the low 20s.

As you can tell by this example, both the short and long puts increased in value, but the long puts increased by a greater amount because of the time to expiration and the effects of vega. Conventional wisdom would say that the option writer would be at a disadvantage during a spike in volatility. However, the Calendar Condor typically takes advantage of an increase in volatility because of its vega value. Remember, the short positions will decrease the ability to profit because of the increase in the VIX. However, your long positions increase more than the short positions on a relative basis and you will now be able to sell higher premiums against the long position.


As mentioned in “Positive alpha, negative beta in all markets,” June 2006, we would recommend a “position roll” where we simply purchase back our short put positions (June 1275 puts) and sell premium further away in time and in strikes (June 1250 puts or July 1225 puts). In this scenario, as the market began to drop from multi-year highs, we would have rolled our June 1335 call positions down to June 1300 calls in the same month to take advantage of theta. This provides a reduction in delta, a lower risk profile and maintains a risk/reward profile that has more potential for profitability.


Now that we know what happens to the calendar condor, let’s take a look at the straddle. We can analyze volatility’s effect on an options price by looking at the price of at-the-money options before and after a volatility spike.

Through the three day period, as the VIX increased by 3.64 points (27%), the spread of the June 1295 straddle increased by $13.00 (37%). The underlying asset (S&P 500) fell from 1295.00 to 1263.10 (2.46% loss). In “Soaring straddles,” below, the closer-to-the-money options will always be affected more significantly than options that are farther out-of-the- money. However, in this very short term period, it is easy to see that the option buyer would benefit significantly from this spike.


Until recently, volatility levels were near 8- to 10-year lows, causing premiums in options to deplete significantly from where they were a few years ago. During the period of late 2004 to mid 2006, the market seemed to pitter patter in an extended trend upward as market volatility stabilized at lower levels into the low teens. The low volatility markets created a situation that led many option writers (sellers) to sell options much closer to the money to collect relatively the same amount of premium as was collected when volatility was much higher. If and when there is a spike in volatility, the short seller of close to the money options will be at more risk (see “Closer to the fire,” below).

Just by viewing the difference in the pricing you can see that selling options 50 points away from the money differs completely in a high volatility versus a low volatility situation. A higher VIX in 2002 can be attributed to a precipitous fall in equities following the terrorist attacks of September 11, but the pricing of the options can be attributed to a few more factors.

First, the average daily trading range during 2000 and 2002 was 22.02 and the VIX was running in the mid 20s; whereas the average daily trading range during 200 and 2005 was 10.39 and the VIX was running in the low to mid teens.

Another aspect regarding options that needs to be understood is that even though both a put and a call 50 points out-of-the money and with the same amount of days to expiration should theoretically be valued at the exact same price, they rarely are. In the real world they are not priced equally because of a volatility skew (a skew is a bias in the market to one direction). You should notice that the puts are worth much more than the calls on a relative basis.

Therefore, the volatility skew in this market is biased toward the downside. Much of this has to do with the fact that risk is priced into put premiums because of the market’s ability to fall more rapidly at any given point in time than it might rise.

Options are an extremely unique and dynamic instrument. Although volatility is one of the most important factors in the pricing of an option, several other factors play a role and must be kept in close check. These include, but are not limited to, overall market trends, interest rates, time and the underlying asset. These other factors must be considered, and usually are, but when a trader scratches his head because the price of his option is not where he expected it to be, it is usually because of a change in volatility. Volatility affects option prices as much as any other factor.

Jes Santaularia is the managing principal and Charlie Santaularia is the managing director at Parrot Trading Partners LLC in Lawrence, Kan, and Sarasota, Fla. E-mail them at or or visit

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