Trading Realized Volatility
So far, we’ve discussed many option strategies in which realized volatility
is an important component of the trade. And while the management of these
positions has been the focus of much of the discussion, the ultimate gain or
loss for many of these strategies has been from movement in a single
direction. For example, with a long call, the higher the stock rallies the
better.
But increases or decreases in realized volatility do not necessarily have an
exclusive relationship with direction. Recall that realized volatility is the
annualized standard deviation of daily price movements. Take two similarly
priced stocks that have had a net price change of zero over a one-month
period. Stock A had small daily price changes during that period, rising
$0.10 one day and falling $0.10 the next. Stock B went up or down by $5
each day for a month. In this rather extreme example, Stock B was much
more volatile than Stock A, regardless of the fact that the net price change
for the period for both stocks was zero.
A stock’s volatility—either high or low volatility—can be capitalized on
by trading options delta neutral. Simply put, traders buy options delta
neutral when they believe a stock will have more movement and sell
options delta neutral when they believe a stock will move less.
Delta-neutral option sellers profit from low volatility through theta. Every
day that passes in which the loss from delta/gamma movement is less than
the gain from theta is a winning day. Traders can adjust their deltas by
hedging. Delta-neutral option buyers exploit volatility opportunities through
a trading technique called gamma scalping.