Volatility.
To some this term conjures up images of see-saws and roller coasters. Some love it, others hate it. For some it’s a profit giver, for others it’s a profit taker. In the world of options, volatility is often the primary variable influencing an option’s price. Though options do their best in forecasting an asset’s future volatility, they often get it wrong.
How wrong?
Wrong enough to shift the odds in favor of those entering short volatility strategies. So says Jared Woodard, principal of Condor Options, in his recently published eBook Options and the Volatility Risk Premium.
As an avid reader of Jared’s blog I was excited to dive into his eBook and see what kind of revelations were in store. At 4500 words the eBook is relatively short and to the point. Woodard sticks to the task at hand and avoids embellishing on any tangential issues. The content seems to be tailored primarily toward professional traders and others well grounded in option theory. I suspect sophisticated retail option traders may also enjoy the material. It is essentially divided into three sections which (a) introduce readers to the definition of the volatility risk premium (b) provide evidence for the existence of this volatility risk premium in the options arena and (c) present ideas for “estimating, predicting, and trading the volatility risk premium.”
Initially readers receive an in-depth explanation of the volatility risk premium (VRP). In the options market this VRP exists “when the volatility implied by those options is higher than the subsequent volatility realized by the underlying asset during the life of the option.” Woodard included an enlightening example of the theory behind a “perfectly priced option”. Though I’ve read commentary on it before, I found Woodard’s approach to be particularly easy to follow.
When providing evidence for the existence of VRP in different asset classes, the discussion turns decidedly more “mathy”. Those unwilling to simply accept Woodard’s assertion that VRP exists will find ample data to back up such a claim. Admittedly there were too many numbers for a simpleton like myself.
Of all the pictures included in the book, I found the one displaying the seasonal volatility of the S&P 500 over the past 30 years to be most illuminative. We’ve all heard (and most have seen) the tendency of the market to exhibit low volatility toward the end of December and during the summer months as well as high volatility in October and November. Woodard investigates these seasonal tendencies and quantifies the extent to which they exist.
Because of the persistent VRP built into option prices, Woodard concludes that traders should be “oriented toward being net sellers of options”. Despite the occasional shocks that occur to short volatility strategies (think 1987 and 2008), a “sizable and economically meaningful” edge still exists for vol sellers.
Options and the Volatility Risk Premium can be found on the FT Press and Amazon.
{ 7 comments… read them below or add one }
Hey Tyler,
I commend anyone who has the guts to write a book or blog on volatility. There are more webinars, conferences and books on volatility than ever before. Some approach the subject from a practical side e.g. odds favor the sellers of vol e.g. Mr Woodard above. Others compare different time frames of implied volatility of options to various time frames of volatility of the underlying in an effort to find ‘the edge.’ Others note seasonal volatility opportunities e.g. Mr Woodard. Others look to synthesize maximum excursions of the underlying and their pivot points with trades constructed with hedged spreads whose short positions decay OTM.
Using one method e.g. selling options when the vol is high or buy options when the vol is low never works all the time-selling options may work more of the time than buying options but this is a misleading statement. For example, higher/lower volatilities can crush profitable positions in one day when volatilities can move 25% or more especially during earnings or when earnings and expiration fall close to one another.
The common denominator which keeps appearing is trading volatility; I mean this as trading volatility as an asset class. For example, this means learning and investigating the relationship of different volatilities to one another e.g. diff time frames of IV to one another, diff time frames of HV to one another and different time frames of IV to diff time frames of HV. This is particularly true during expiry week or weekly options when time decays and IV collapses exponentially in seven to ten days and can offer many advantageous conditions to options traders.
Mr Woodard or anyone deserves a Nobel Prize if they can put together a book or thesis which coherently explains the asset class concept to traders and non traders alike.
I am researching views on strategies for the home-based investor. Your site helps to understand how strategies work. Is it a good idea for the non-pro to go beyond simply buying calls and puts? Do the trading platforms even allow non-trivial strategies at all for this kind of investor?
butterfly option,
Though calls & puts are typically the first option strategies learned by most traders, they are actually the most aggressive and hardest to profit with. Rather than recommend beginning option traders stay with trading call and put options, I encourage them to venture into strategies like covered calls and spreads ASAP. The only people I’ve ever met that make money consistently with buying calls and puts are pros. I assume when you say “trading platforms” you’re talking about brokers? Nowadays anyone can open up a brokerage account and have the ability to trade more complex option spreads. It is certainly not limited to the “pros”.
I have been looking at many sites and found yours extremely useful. There is clearly lots to learn on this subject. Can anyone recommend other good places to search for this information?
Here are a few other option education related sites you might like:
http://blog.mdwoptions.com/
http://www.optionseducation.org/
And here are a few of my option books of choice:
Options for Rookies by Mark Wolfinger
Options as a Strategic Investment by Lawrence G. McMillan
Option Volatility Trading by Adam Warner
Hope that helps-
Another great book on options is called “Using Options in Wealth Management” by Geoff Considine. It is only available in ebook format, but definitely worth the read.
Thanks for the addition Daniel. I’ll have to add it to my lengthy “to read” list.
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