Handling volatility in options premiums while trading direction

Reading Time: 3 minutes

The biggest displeasure is to face “Unwelcomed” characters along with the Welcomed ones. For example, a peel with a banana or seeds with any fruit. I hope we have got the analogy right.

While neither of these peels and seeds brings in pleasure yet we have to agree that they have a critical role to play in the existence of the fruits.

So, we accept them and learn to live with it. As a common practice without complaining we take off the peel and get rid of the seeds. Just like these fruits, Options also come with its sweetest utility of inherently favorable risk-reward but the seed here is Implied Volatility especially when our focus is on trading those options solely for a directional move.

Talking about it now is more important than ever because of two reasons -

1. Implied Volatility (IV) is directly proportional to Option Premium. When IV rises the Premium rises and vice-versa without the underlying price changing at all.

2. Normal situations do not warrant extra attention but COVID-19 triggered uncertainties are leading to big moves in IVs and thereby creating undue volatility in Option Premiums.

#Remedy 1: Understand the Enemy

Handling these bouts of volatility in options premiums can be done in many ways but half of the work would be done only by appreciating the possible change.

Now before we do that, most of us now know that Implied Volatility (Volatility figure back-calculated from Options Premium) is negatively correlated with the indices.

The most talked-about India VIX index is often used as a proxy to the implied volatility of Nifty Options. Nifty went lower and VIX went higher and the other way round in the recent bounce.

While this may not bother us a lot in usual options trading but we may need to pay extra attention especially now. So, accounting for a fact that a winning Buy Call will mostly get punished by rising underlying and alongside falling IV (thereby slower rise in premium).

On the other hand, Winning Put would get an extra boost from falling prices and alongside rising IVs.

The second notable thing is, stop-losses on bought Puts need to accommodate for two things, rising underlying prices as well as falling premiums due to falling IVs.

Similarly, the Call bought has to make sure that move is large enough that compensates for a slower rise in premium due to falling IVs when the underlying is going up.

So bigger targets and relaxed stop-losses need to have adhered to option buying trade for directional trading.

#Remedy 2: Accounting for IV movement

In normal situations, we might have straightway gone to the spread route to address this problem but the recent violent moves have dried up the liquidity in options to a great extent.

Hence, considering it’s just that one single strike around the stock price we get to trade, we need to account and accommodate for fall in IVs in that single option only.

Analysing and forecasting IVs is a science in itself and way beyond the scope of this discussion but what we can do, is to get some sort of approximation in place so that we do not get grossly disappointed. We will try and achieve this in a two-step process.

Step 1:

Get the details of the option that we want to trade and plug it into any application or internet-based option calculator that we are familiar with.

Once this is done, let the calculator get you the current IV of that option.

Step 2:

Now revalue the same option especially for a Stop-Loss of the Put or Target of the Call by inputting the Underlying forecast, reduced time to expiry (if the trade is intended to be carried forward) and most importantly IV = Step 1 IV – (10% of Step 1 IV).

I know this is not an exact science but considering the trade is just for a day or two and considering the trade still gives economically favorable pay-off after taking a 10% hit on IVs, at least there will not be a big negative surprise hidden for us in the trade.

Finally, always beware of the impact of IV amid the COVID-19 crisis because seeing an options trade go wrong despite the right underlying forecast is most frustrating.

(The author is CEO & Head of Research at Quantsapp Private Limited.)

Disclaimer: The views and investment tips expressed by investment experts on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.

Learn and read more about What are derivatives from Quantsapp classroom which has been curated for understanding of futures contract from scratch, to enable option traders grasp the concepts practically and apply them in a data-driven trading approach.