Most traders consider sophisticated option strategies complex financial instruments, designed for pros only. As such, these techniques are often overlooked as a way to tap changes in volatility as a source of returns. However, volatility-oriented trading strategies can stabilize an investor’s portfolio because of their non-correlation to traditional investments. Volatility-based strategies can reduce overall portfolio risk and provide insurance against external shocks.
Theoretical foundations for volatility were laid by the German mathematician, Gauss, as in the Gausschen normal distribution, which works on the principle that coincidental values fluctuate around a middle value in the shape of a bell curve (log normal distribution). Economists Harry Markowitz, Fisher Black, Myron Scholes, Robert Merton and William Sharpe expanded on this in their formulas regarding portfolio theory and option-pricing models (see “A Black-Scholes Peek at Futures Prices”).
The definitions of volatility refer to the time of the calculation and the dates that serve as a basis for that calculation. Historical volatility refers to the actual annual variance of profit to prices. Implicit, or implied, volatility is calculated from current market variables using an option-pricing model. On the basis of these two volatilities, the options trader estimates expected volatility and if he is correct, the expected volatility correctly forecasts the future volatility.
Options theory assumes constant volatilities for different options. Sophisticated analysis software allows different base prices and terms to be displayed graphically. In this way, volatility resembles a rough ocean with continuous waves and changing wind directions and strengths. Experienced options traders can ride the virtual waves to generate non-correlated profits with minimal relative risk.
The different volatility profiles are also described in terms of skew/smile. Skew/smile is the volatility curve cross-section. A number of options strategies are available to profit from deviations in these: straddles, strangles, vertical spreads, calendar spreads and many more. The constantly changing market risk is balanced out by the basic values that make up delta hedging. The delta displays how strongly an option or an option portfolio has been influenced in its option price by the market direction.
SKEW/SMILE
Skew/smile shows a cross-section of the volatility surface and allows us to calculate implicit volatility independently of different basic prices at a given term (see “Smile vs. skew” ). For most individual equity and index options, the lower the basic price, the higher the implicit volatility, as extraordinarily strong negative price crashes occur more often in practice than is accepted in theoretical models.
This attribute is why options buyers pay higher risk premiums (or sellers demand higher premiums) for put options, which are expressed in the form of higher implicit volatilities. In addition, investment funds often acquire shares via buying from put holdings and simultaneously selling covered calls. Additional premium income can thereby be cashed and can still have a negative effect in the case of extremely quick rising markets due to missed price profits. In practice, quick price movements tend to go down. Upward movements tend to take place in an ordered and slow fashion.
A steep skew gradient can result from two factors: the risk attitude of the market participant or supply/demand forces, according to hedging elements. These factors are constantly changing so that options with the same basic price, but different terms, can display different implicit volatilities, and the skew curve can have a flatter or steeper distribution. Furthermore, the skew for interest and currency options is quite different to that of share options.
“Volatility surface” shows the implicit volatility of options for different strike prices and expiration dates. The chart reflects the different volatility sensitivity of individual expiration months and certain peculiarities, such as several bank holidays, when there is no trading.
STRATEGY TYPES
On their basic level, volatility-based strategies can be differentiated as volatility spread trades and gamma plays.
An example of a volatility spread would be to sell short-term options (front month) with a high implicit volatility while at the same time buying the necessary number of one-year options with a low implicit volatility to achieve delta neutrality.
This can be accomplished with short and long straddles or also by simple call-call or put-put combinations with the same approximate value and price. In this way, a virtually market-neutral position is established that can be managed by delta hedging. A trading profit would arise if the premium of the short-running options declined more quickly and strongly than the delta hedging in the one-year options.
In contrast to the relative volatility spread strategy, in a gamma trading strategy, you’re betting that the implicit volatility of an option does not agree with expected volatility. In other words, the trade hopes for a change in the absolute level of volatility in the market. The aim of a long gamma trade is a particularly large profit on the back of an external shock, such as surprise election results, a geopolitical shock, unexpected large corporate profits or environmental catastrophes. The short gamma trading strategy instead bets on quieter waves, or better still, no waves at all.
In the case of both volatility strategies, market direction plays only a subordinate role, or in some cases, no role. This makes these techniques excellent elements for diversifying a portfolio of traditional strategies, which depend on market direction for their profits.
STARBUCKS CASE STUDY
The market situation for Starbucks, the Seattle-based coffeehouse giant, provides a good current example of a directional single volatility trade.
The current fundamentals show Starbucks’ total debt-to-capital ratio increases from 0.15% in 2004 to 35.52% in 2007. At the same time, Starbucks has underperformed the benchmark S&P 500 index and is seemingly threatened by potential fears of a macroeconomic slowdown. High financial costs, bad conditions on the global money markets and a meltdown in coffee consumption overall could possibly lead to big uncertainty in the sustainability of the Starbucks’ business model — at least at the level of its current scope of business.
The financial results for the first fiscal quarter 2008 were mixed. A slight increase in net income was faced with an increase in interest repayments left over from a previous year. On the other hand, Chairman Howard Schultz recently announced weak stores would be closed and the product line would be changed to re-focus on the company’s core. Both scenarios, along with the current precarious fundamental situation, create uncertainty and offer an opportunity for a volatility trade.
Typically, when trading volatility, market uncertainty and surprises are your best friends. With equities, it is best to focus on stocks with a mixed business outlook and a consensus/reality gap. Ideally, the fundamental situation should be composed of strong opposing views in the market. From a technical point of view, you should look for consolidation in volatility, especially before earnings releases or any announcements that could dramatically influence stock price.
Starbucks’ technicals show a wedge on the daily chart with lower highs and strong support at $18 (see “Shot down”). Currently, Starbucks is breaching the interim descending line and will possibly resume trending strength. That Starbucks has technically abandoned the trading wedge means that 10-day volatility can rapidly accelerate. Although this breaching demonstrates a possible return of the bull in Starbucks, we don’t want to be tricked into betting solely on direction. We want to focus on a potential volatility expansion breakout in either direction. That said, given that the upside appears to be favored, we can weight our strategy with a bullish bias as we build our options strategy.
The 10-day vs. the 30-day historical volatility has recently widened, and the 10-day volatility, after finishing the strong bearish down move, dropped from 33 to 14 and consolidated slightly above 15. In terms of implied volatility, call implied volatility plunged heavily from 55 to 35, with an indication it might advance back to the 45 area.
There are a couple ways to play the rapid drop in volatilities, with a high likelihood of an intermediate-term recovery. Either a long straddle or a ratio calendar back call spread would exploit a resumption of recent higher volatility figures. With fundamental analysis suggesting a slight upside bias to the stock, the long 2:1 straddle is probably the best bet. This strategy would involve buying two three-month at-the-money calls and buying one three-month at-the-money put. In terms of trade management, we would sell the put at $14 on the downside and the calls at $25.
“Profit profile” shows how the position performs with various values for Starbucks at different dates prior to expiration. It shows that we only stand to lose money if the stock remains between roughly $16.50 and $20. We’ll make the most money on the high side, thanks to the two calls, at $24.11.
Too often, traders think that a market can only go up, go down or stay the same. This may be the case for price, but it ignores the attribute of volatility and the power of options to tap into this often hidden market quality for non-correlated returns.
Hendrik Klein is an expert in volatility arbitrage trading and the head portfolio manager at Da Vinci Invest Ltd., a hedge fund based in Zurich, Switzerland. Reach him via the Web site www.davinci-invest.ch.
