Q&A

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Explore Your Options

Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the STOCKS & COMMODITIES website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C.

Tom Gentile of Optionetics

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DOES VOLATILITY MATTER FOR SHORT-TERM TRADES?

I trade call options on a short-term basis. I typically hold positions from one to five days. The only factor I consider when trading call options is delta. I usually pick options with 30 to 60 days until expiration. My target delta is 0.75, but I will trade options with 0.65 to 0.85 deltas. For the most part the options I trade do follow the stock price closely, as prescribed by delta.

My question concerns the option's volatility. I do not consider volatility whatsoever when selecting the call option to trade. Am I doing myself an injustice by not paying attention to volatility? Does volatility matter when trading for the short term? Would I improve my chances for greater gain by considering volatility? If so, what should I look for? Thanks.--George

Thanks for the question. As you know, several different factors can affect the value of an option contract. The most important is the price of the underlying asset. In your example, you are trading equity calls, and the price of the stock will be the single most important factor in determining the value of the call. If the stock price rises, the call will increase in value. If the stock price falls, the call will decrease in value.

For readers who are not familiar with the "greeks" in option trading, delta measures how much the value of the option will change for changes in the stock price. A delta of 0.75 tells us that the value of the option will increase in value by 75 cents for each $1.00 increase in the stock price. Deltas are always changing. In addition, since the stock price is the most important factor in determining the value of the call, it does make sense to focus on delta. I agree with you there.

Time decay is another factor that will affect the value of an option contract. Since options are contracts with fixed lives, they lose value over time. Theta measures the impact of time decay. For example, a theta of 0.05 tells us that the option will lose five cents each day. In your example, where the option is being held only one to five days and the options have 30 to 60 days until expiration, time decay will have a minimal impact on the trade. Nevertheless, theta is also a factor to consider any time you are buying a premium.

Volatility can also influence the value of an option premium. When we talk about volatility and options, we are often talking about implied volatility (IV), which is embedded in the option premium. IV is computed using a model and reflects the market's expectations about the future volatility of a stock. Many brokers and option analysis software packages allow users to compute and make charts of implied volatility. A complete discussion of this important concept is beyond the scope of this column, but for now, let me say that when IV is high, the option premiums are more expensive. When it is low, the premiums are cheaper. That's why traders often say they want to buy volatility when it is low and sell it when it is high.

Implied volatility is always changing and affecting premiums. Vega measures how much the value of the option will change for each 1% change in implied volatility. For example, if an option contract has a vega of 0.05, the premium will increase by five cents for every 1% increase in the value of the stock.

When the strategist is simply buying calls and holding them for one to five days, implied volatility is not likely to have a major impact on the trade under normal conditions. However, it can in some situations; it is not uncommon to see implied volatility rise ahead of an earnings report as the market begins pricing in the risk of a big move in the stock following the news. Then implied volatility will fall after the report is released. The rise in premiums ahead of the news is known as a volatility rush. The decline after the fact is a volatility crush.

If the strategist buys calls just ahead of an earnings announcement or some other known event, there is a risk that they will be buying premiums that are high due to the increase in implied volatility. For example, Google (GOOG) is due to report earnings and the implied volatility of the short-term call with a delta of 0.75 is 70% ahead of the news. Vega is 0.10. If implied volatility falls back to its normal range of approximately 35% after the report, the option premium would be expected to fall by $3.50 (0.10 x 35%), and the call, which now trades near $20, will lose 17.5% of its value due to the drop in volatility alone. In short, you want to pay attention to implied volatility to avoid getting in a volatility crush. As a call buyer, it will work to your advantage to buy it when it is low. Historical charts of implied volatility are available through some brokers and option analysis software, including our Optionetics Platinum software.

Delta, theta, vega, and implied volatility are all computed using option pricing models and available through most brokers and option analysis software. When buying short-term calls, clearly, delta is the most important variable to consider. However, theta and vega should not be overlooked. Theta will tell you how much time decay is affecting the position. Vega will tell you how implied volatility might affect the trade.

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Originally published in the June 2007 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2007, Technical Analysis, Inc.

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