Generally speaking, the more volatile the underlying asset the more valuable the option will be. Why is this? In most traditional schools of finance, volatility is treated as risk and something to be avoided.
Why is higher volatility associated with higher option prices? It is important to remember that option pricing is all based upon probabilities.
Beyond ‘death and taxes’, nothing is certain to happen; but the probability of something happening or not will drive an option’s value.
In the following graph we see the return distribution for three different assets.
- The red curve represents an asset with a normal distribution.
- The blue curve is an asset with low volatility – the probability is that most of the prices will be rather close to the mean price.
- Alternatively, the green curve represents a highly volatile asset, where the price is quite unpredictable.
There is a rather large range of plausible outcomes.
Source: www.lisashea.com, Swan Global Investments
Superimposed over these three distributions is an orange straight line representing the strike price of an out-of-the-money call option. If the asset price exceeds the option’s call price, the option goes in-the-money and becomes worth something. It could potentially be worth a lot.
In the graph above we see how more volatile assets have a greater possibility of their options going in-the-money. Naturally it follows that such options would be worth more. Of course volatility will also impact the value of put options in the same way; a more volatile asset’s put options will also be more valuable.
So how does this then work out in the marketplace? How do the prices that investors pay for options reconcile against actual volatility conditions?
These questions get to the crux of what is known as ‘volatility harvesting’ or premium collection strategies. These strategies seek to capitalize on the difference between implied volatility (i.e., what market participants are willing to pay for options) and realized volatility (i.e., how markets actually fare after the
In the following graph we see the historic relationship between the two. More often than not markets tend to overestimate the amount of volatility that will be in the market.
- The blue line is the VIX, which is the implied volatility of the market.
- The red line is the actual, realized, after-the-fact volatility.
The gap between implied and realized volatility can be a source of profit if one systematically sells overpriced options and collects the premium, and then buys them back at a lower price at a later date.
Source: Bloomberg and SG Financial Engineering
Of course, this trade won’t always be profitable. There will be times when the margin between implied and realized volatility is small, limiting the profitability of the trade. Worse, there are times when the relationship inverts and the realized volatility is higher than the implied volatility, in which case a volatility harvesting strategy will most likely be unprofitable. Those times are seen in the red, “negative spread” areas of the above graph. But more often than not volatility is overpriced and can be exploited for profit.
Systematically collecting option premium from the sale of short-term puts and calls is one of the three primary drivers of the Defined Risk Strategy. Along with a buy-and-hold equity position and the downside hedge, the premium collection piece represents the market-neutral return component of the DRS.
In a future blog post we will examine the challenges faced by those who try to profit from volatility by utilizing VIX futures.