One of the most integral part and probably only one subjective factor in the Options premium calculations is the ‘Volatility’.
As the rest of the 4 factors used in the calculation of option premium viz.- Underlying Price, Strike Price, Time to Expiry & Risk-Free Rate of Interest - do not have any different answers.
Given the rest of the four known factors and the premium traded in the market, the volatility figure is called ‘Implied Volatility’.
Now, since the rest of the 4 factors are already known, any significant change in Premium without any significant change in underlying price and time to expiry can now be attributed to change in the Implied Volatility.
Higher premiums are attributed to higher implied volatility and lower premiums are attributed to lower implied volatility.
One could wonder why something like that would happen that with the same time to expiry and the same price and strikes, two different points in time have two different premiums.
The answer is in the understanding of the reason behind such anomaly, which brings us to the only logical explanation is that the option implied volatility is forward-looking volatility.
This figure would also have some expectation built into it as far as future volatility of the underlying is concerned. Considering the recent situation where holiday season brought in inactivity and its expectation brought in a very low implied volatility environment. Such times call for a few modifications while trading options.
Buy More Sell Less
Since options implied volatility is lower — it is not discounting any big move and thereby keeping the premium value lower. Any directional move should be traded with a buy in Option.
This would help in two ways - number 1, the move comes around, and the incremental realized volatility would raise the prices of options, and number 2, the sheer direction that would help the option premiums to go up.
Avoid Net Sell Option Strategies
Options are often used in combinations, and many times with more sell quantity than buy. This is done to articulate the low directional intensity of the strategy.
However, these strategies should not be resorted to in low volatility environment. Simple reason being, Volatility in itself has a mean-reverting characteristic.
This means extremely low Volatility (in our case Implied Volatility) cannot sustain for a long time. So just in case we are net sellers of options and the implied volatility were to mean revert and go higher from the lower extreme we would tend to lose.
This is especially to be taken care of by the regular sellers of the options (Far off Call & Put Sellers).
Keep an active Hedge
Like we learned that the Implied Volatility is a function of realized volatility, remember the lower extreme could invite a spike in realized volatility too.
As the law of nature holds, destruction is what is speedier than construction. So, more often than not we would have a down move associated with rise in volatility.
So, third modification is for the trading portfolio that one holds, there should be a hedge protecting against any such violent down move at all times.
In times of low volatility, a little bit of tweaking would help in avoiding any mishaps, unless we are trading a predefined model that induces trades accounting for such situations.
(The author is CEO & Head of Research at Quantsapp Private Limited.)
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