It’s All About Volatility
What are Kim and Mick really trading? Volatility. The motivation for
buying an option as opposed to buying or shorting the stock is volatility. To
some degree, these options have exposure to both flavors of volatility—
implied volatility and historical volatility (HV). The positions in each of the
examples have positive vega. Their values are influenced, in part, by IV.
Over time, IV begins to lose its significance if the option is no longer close
to being at-the-money.
The main objective of each of these trades is to profit from the volatility
of the stock’s price movement, called future stock volatility or future
realized volatility. The strategies discussed in this chapter are contingent on
volatility being one directional. The bigger the move in the trader’s
forecasted direction the better. Volatility in the form of an adverse
directional move results in a decline in premium. The gamma in these long
option positions makes volatility in the right direction more beneficial and
volatility in the wrong direction less costly.
This phenomenon is hardly unique to the long call and the long put.
Although some basic strategies, such as the ones studied in this chapter,
depend on a particular direction, many don’t. Except for interest rate
strategies and perhaps some arbitrage strategies, all option trades are
volatility trades in one way or another. In general, option strategies can be
divided into two groups: volatility-buying strategies and volatility-selling
strategies. The following is a breakdown of common option strategies into
categories of volatility-buying strategies and volatility-selling strategies:
Volatility-Selling Strategies Volatility-Buying Strategies
Short Call, Short Put, Covered Call, Covered Put,
Bull Call Spread, Bear Call Spread, Bull Put
Spread, Bear Put Spread, Short Straddle, Short
Strangle, Guts, Ratio Call Spread, Calendar,
Butterfly, Iron Butterfly, Broken-Wing Butterfly,
Condor, Iron Condor, Diagonals, Double Diagonals,
Risk Reversals/Collars.
Long Call, Long Put, Bull Call Spread, Bear
Call Spread, Bull Put Spread, Bear Put Spread,
Long Straddle, Long Strangle, Guts, Back
Spread, Calendar, Butterfly, Iron Butterfly,
Broken-Wing Butterfly, Condor, Iron Condor,
Diagonals, Double Diagonals, Risk
Reversals/Collars.
Long option strategies appear in the volatility-buying group because they
have positive gamma and positive vega. Short option strategies appear in