Who is The Volatility Trader?

A lot of investors would describe themselves as “volatility traders” but what does this really mean? If buy an option are you trading volatility? The key to this is to understand the option’s sensitivities – the so-called “Greeks”. The two important ones here are delta and vega. Delta measures the sensitivity of the option value to changes in the price of the underlying. That is how much will the option value change if the underlying moves by some amount? If an option is a “50 delta” it moves half as much as the underlying and in the same direction i.e. if the underlying goes up by 1, the option should gain 1/2. And if the underlying goes down by 2, the option should lose about 1. The analogous thing is true for a -50 delta option – it changes half as much as the underlying but in the opposite direction – going down by half as much as the underlying goes up and going up half as much as the underlying goes down. Long call options and short put options have positive deltas while short calls and long puts have negative deltas.

Vega measures the sensitivity of the option value to the volatility of the underlying. In this case the measure is in terms of absolute changes in volatility not percentage changes.If an option is a 10 vega, then its value would go up by 10 cents if the volatility of the underlying increases by 1%. It doesn’t matter if the volatility changes from 10 to 11 (a 10% increase in volatility) or from 20 to 21 (a 5% increase in volatility) – a 10 vega means 10 cents up or down for a 1%, absolute, change in volatility.Both long calls and long puts have positive vegas. So someone who buys an option definitely gains from an increase in volatility and loses if there is a decrease. So there would be some justification for saying that someone who buys an option is buying volatility and the options seller is selling volatility. But if an option really does have a 50 delta and a 10 vega, then a 1 point change in the underlying price has a much greater effect than a 1% change in volatility. Or another way to put it is that if you are long an option your view on volatility is unambiguous – you want it to increase, but your view on direction depends on what type of option you are long.

Can you isolate the volatility component of the position? Yes and it is pretty simple – just hedge it delta neutral. This means trading enough of the underlying to neutralize the option’s delta. Imagine you are long a 50 delta call on 100 shares of GOOG. To hedge your position you would need to sell 50 shares short. If you did that and GOOG went up 1, you would gain $50 on your option position and lose $50 on your shares. Conversely if GOOG went down $1.

Once you have hedged delta neutral you don’t care which way the spot moves, up or down. This movement does not by itself generate any P/L for your position. What does generate the P/L is the next sensitivity – gamma.

Click here to download a copy of the OCC’s Characteristics and Risks of Standardized Options.