Trading Volatility: Advanced Strategies

Understanding Options Trading

Episode 09 – Trading Volatility: Advanced Strategies

David McGann (00:17):

Hello to all of our viewers. My name is David McGann. I'm a director here at BMO InvestorLine. I'm thrilled to be co-hosting today's webinar on Trading Volatility with Advanced Strategies. This comes to you as part of our webinar series that seeks to unpack options trading. Be sure to check out our Education hub to find other webinars in this series that may be of interest to you. And once again, we'll be joined today with our friends at OptionsPlay, and I'm pleased to introduce Tony Zhang. Tony is chief strategist at OptionsPlay, where he leads development of options trading products, education for investors, and oversees the firm's quantitative options research. He's a frequent contributor to CNBC for analysis on the markets with a specific lens using technical analysis fundamentals and of course options. We're pleased to have Tony back. I know we have some great content to review today on Trading Volatility with Advanced Strategies. And with that, Tony, I'll hand things over to you.

Tony Zhang (01:12):

Yeah, thank you so much, Dave, and thank you so much everyone for viewing this. As you said, this is really the culmination of the series of options that we've learned so far with regard to the webinars that we've taught. And helping you better understand how you can take some of the strategies that we've learned, some of the fundamental building blocks that we've learned and start applying them to some advanced strategies. Such as trading volatility, specifically implied volatility. We'll take a look at what that means, the strategies themselves and helping you better understand how to navigate these specific advanced strategies. Let's go ahead and get started.

(01:52):

Now, before I do, what we are going to discuss here today is purely for education and demonstration purposes. It is not a solicitation or recommendation to buy or sell any of the specific securities that we might be using as example purposes during today's session.

(02:09):

What we're going to break down during today's session is first getting a better understanding of what implied volatility even is before we can look at how you can potentially trade it. In order to do that we have to better understand the option Greek. We'll do a quick review of the option Greek, specifically the important ones for today's discussion for the strategy that we'll be looking at. How the different Greeks will affect the value of your option? And then we'll look at the difference between buying versus selling volatility. What that means in terms of buying volatility, what that means in terms of selling volatility, and what type of market and environments might be beneficial for these types of strategies. Then we'll talk about different spreads and different straddles that will allow you to take advantage of a specific view that you might have for implied volatility on a stock or an ETF.

(03:01):

Let's jump right into it. But the primary thing that I want you to be able to walk away from today's session is a clear understanding as to how can I gain exposure to changes in implied volatility using option strategies? Specifically the more advanced option strategies that you can trade for this specific type of outlook that you might have on the overall markets.

(03:23):

So, let's start off by first understanding implied volatility. Because there might be some confusion as to what that means. There's lots of different types of volatility. What are we referring to when we say implied volatility? In order to better understand that we have to look at how does an option premium or the price of an option, or what consists of the price of a specific option?

(03:46):

And when we think about an options price, there's really two primary components that make up the options price. There's the intrinsic value of the option and there's the extrinsic value of the option. If we look at the intrinsic value of the option, that is what we consider the option in the money value of the option. Meaning how much is the option in the money buy, and that is simply determined by the difference between the strike price and the current price of the stock. That's something that you and I don't really have any control over, of that intrinsic value. And then there's extrinsic value, which is the time value and implied volatility component of it. These are external factors that affect the value of an options price. So, think about how much time is left between now and the expiration of an option that you have control over in terms of which expiration you might want to choose.

(04:41):

And then there's implied volatility. That's effectively the market's expectation for future volatility. So, if a market expects, for example, if let's say there are earnings or some type of economic event that's coming up that might affect the economics of a specific stock or ETF, that's going to have an effect on the implied volatility of that particular stock or ETFs options price. For example, if there's an uncertain event coming up that's going to naturally have a higher implied volatility, and if let's say once that event goes by and the information is now known that implied volatility tends to contract after the event itself. So, it's important to understand these different components that make up an options price. And implied volatility is the component that is determined based on how much uncertainty there is between now and the expiration of the option that will fluctuate as the option price, or as the option approaches expiration.

(05:45):

Now, the higher the implied volatility of an option, the more expensive the option tends to be. And there are ways that we can measure this. Probably one of the more common ways or some the standard ways that we usually think about measuring how the implied volatility of an option is a metric called IV rank. And that's where we compare the current implied volatility of the option compared to how the range that it's traded within the last 52 weeks or the last year. And IV rank gives us a sense for whether we're at the lower end of that range or the higher end of the range? And it's a very simple metric that ranges from zero to 100. If you have a stock within an IV rank of 100, that means the current implied volatility of the option is the highest we've seen over the past year. Vice versa, if it has an implied volatility rank of zero, that means it's the lowest we've seen throughout the last year.

(06:46):

And if it's a rank of 50, that means we're right then in the center with regards to the min and the max of the range that we've seen over the past year. So, it's a simple metric that gives us just a basic understanding of how expensive or cheap an option is relative to the history over the past year. And like I said, there could be macroeconomic events and generally speaking things like corporate earnings or product launches where there's some form of uncertainty as to what the future is going to look like that will generally change implied volatility. When you have events that are uncertain that are about to come up, you tend to get an expansion and implied volatility. And once that event comes by and the information is now known, we typically get a contraction in implied volatility as the uncertainty factor is removed from the price of the option itself. So, that's usually how we think about implied volatility.

David McGann (07:46):

Tony, this slide is wonderful, by the way, and I think that explanation was excellent as well. And what's kind of interesting at the time you and I are recording this webinar for our audience today, it happens to be November 5th, 2024, which is election day south of the border, so it was super unique event. And later this week on Thursday we have the Fed coming out to talk about interest rate policy. Based on what you're describing here, especially the comments around macroeconomic factors can influence implied volatility, is it safe to assume that with an election day today and the Fed making its announcement on Thursday that we're probably looking at an expansion of volatility? Could you expand on that a bit?

Tony Zhang (08:34):

Yeah, that's absolutely right. And this is probably one of the biggest weeks in terms of uncertainty in the U.S. equity markets that we've seen. Just to give you some context around that. Despite the fact that the S&P is within a couple of percentage points of all time highs, which typically is correlated with lower implied volatility, lower uncertainty, we actually have the VIX trading near 52-week highs. We have the VIX at 22%. I don't know the last time we saw the S&P make back-to-back all-time highs and the VIX above 20%, you'd have to go pretty far back to find data points like that. So, this is a good example where between the U.S. election and the FOMC meeting coming up this particular week we see S&P options trade at a very high implied volatility relative to its history, despite the fact that we're near all-time highs, which typically is correlated with lower implied volatility.

(09:32):

So, you're absolutely right, this is a big, big week from a macroeconomic perspective. And that's why we have a relatively high elevated implied volatility on let's say the overall markets such as the S&P 500 options. Let's further break down implied volatility from a trading perspective. Now that we understand what it is, it's also understand the characteristics of it if we're going to trade implied volatility before we even talk about what it actually means to trade implied volatility. The thing to keep in mind and understand about implied volatility or volatility in general, is that implied volatility is what we call mean reverting. And what that means is that it tends to gravitate around an average over the long run. Meaning you tend to have extremes to the high end and extremes to the low end, but overall throughout the entire year it tends to trade around an average.

(10:28):

And typically what we see, especially with equities is that it exhibits some level of seasonality. And this generally seasonality is correlated to the earnings season for most stocks and certain macroeconomic events for perhaps ETFs. Generally speaking, you tend to see an expansion of implied volatility as you approach earnings season, as there's more uncertainty around whether a stock is going to report strong or weak earnings. And then once the report comes out, we typically see a collapse, immediate collapse in that implied volatility. Because that uncertainty factor is effectively removed once that information is released. So, we typically see throughout the year exhibits of seasonality around that earnings season for stocks and macroeconomic events for ETFs.

(11:25):

And what we can do is that the changes in that implied volatility throughout the year can be traded and can be potentially profited if you're using some advanced strategies, such as the ones that we're going to discuss today, to take advantage of these specific changes in implied volatility. You can effectively take, in some of the previous sessions we've talked about how you can utilize options to take a directional exposure. So, if you believe that the stock is going to move higher or move lower, even if it's going to stay neutral, how you can potentially profit from a directional move. But when you're trading options, not only can you profit from a directional move, you can also potentially profit from a change in an implied volatility as well. And that's what we're going to explore during today's session.

David McGann (12:16):

Tony, another quick question for you here on that slide, just talking about changes in volatility. One terminology or term that I've often heard, and I'm sure some of the folks our audience have heard is something along the lines of volatility crush. Is that an example of volatility basically coming down after an event like corporate earnings for example? Is that a term you're familiar with? And can you expand on that and does that fit into this example here of implied volatility and how it essentially moves?

Tony Zhang (12:51):

Yeah, absolutely. And volatility crush` is certainly one of the events I would say that you would typically associate with trading volatility. Because volatility crush is referring to the collapse of an implied volatility right after an event comes out where the uncertainty factor of something is removed. So, most commonly it's around earnings. Stocks report earnings four times a year, and once that earnings event comes out we typically see implied volatility will collapse by a certain amount right after the event itself. And that collapse we refer to as volatility crush. So because the volatility or the implied volatility of an option is effectively crushed to a lower level. So yes, absolutely implied volatility crush, doesn't have to just be on earnings, it could be macroeconomic events as well. But most commonly it's associated with earnings because that happens most often four times a year where you get that collapse in implied volatility immediately after the event itself where the uncertainty factors removed, and implied volatility will come in right after the event itself.

(13:59):

And that becomes a tradable event, because you're effectively taking a view that at a certain point the implied volatility of that option will come in and lower in value over a very short period of time.

David McGann (14:14):

Great, thank you.

Tony Zhang (14:17):

In order to better understand our ability, [inaudible 00:14:22] advanced strategies to take a directional view on implied volatility, we have to review three important option Greeks. Now, these are Greeks that we reviewed before, but I think it's important to understand the three Greeks that I think are going to be relevant to today's session as we discuss some of these advanced strategies that can allow you to take advantage of a view of implied volatility. And that's going to be Vega, Delta and Theta. Let's review Vega first. Usually we talk about Delta and Theta when we talk about Greeks because those are the two Greeks that have the largest impact on the value of the option strategy that you trade. But today we're going to start with Vega. Because Vega measures the change in the options price for every one percentage change in implied volatility.

(15:14):

We always state implied volatility in percentage terms. So, when we talk about Vega, we're talking about how much did the value and option expect, or how much do we expect the value and option to change if the implied volatility of the option either increases by 1% or decreases by 1%? And whenever we're talking about option strategies to take advantage of implied volatility, what we generally want to have is maximum Vega exposure. Meaning an option that we're trading that will have, that will be relatively sensitive to changes in implied volatility. And what we're trying to do is effectively maximize Vega so that we can maximize our exposure to those changes in implied volatility. For example, if we're taking a view that implied volatility is going to come in or collapse, we want some type of option strategy that gives us exposure to a collapse in applied volatility, we're going to use Vega to help us measure how much exposure do we actually have when we're looking at an option strategy.

(16:17):

We're going to look at different option strategies and help you better understand just how much Vega exposure you generally will have with each one of those strategies. Now however, you can't just take an option strategy and have Vega exposure by itself. Every option strategy will have exposure to other things as well. Changes the underlying price, changes the time. So when we think about getting exposure to implied volatility, generally speaking, what we're trying to do is we're trying to maximize our exposure to Vega. But at the same time trying to in some degree minimize our exposure to Delta and potentially have Theta work in our favor. So, just as a recap, Delta measures the change in the options price for every $1 of change in the underlying price. For example, if we have a stock with, I'm sorry, an option with the Delta of 0.5, that means if the stock moves to buy $1, the option price will move by half as much or by 50 cents.

(17:23):

Again, whenever we're trading implied volatility, we generally want to minimize that Delta component of an option that we're trading. Because that is going to affect the value and option based on the changes of the underlying price. Which we may have a view in the underlying price as well. But generally speaking we want to minimize that, because changes in Vega where implied volatility is working in our favor could be offset by changes in the underlying price itself. So, we're trying to minimize Delta to some degree while we're trading these types of strategies.

(17:57):

And lastly, Theta. Theta measures the changes in the options price for every one day passes buy in time. And time as far as I know continues to march on, regardless of what our views are on a specific stocks implied volatility or directional view. So generally speaking, whenever we're taking a view on implied volatility, we generally prefer option strategies where time value is working in our favor.

(18:25):

So for everyday we're holding onto the trade time value is eroding and we are capturing some kind of time decay. Because that means that as implied volatility potentially works in our favor, we also have the Theta component working in our favor, not against us. Those are some of the Greeks that are going to be very important to understand and that you're going to have exposure to that. You're going to want to figure out what the different variations are going to be, with different strategies. And we're going to review that with each of the advanced strategies that we're going to look at during today's session.

(19:02):

Let's talk a little bit about the two different views that you might have with implied volatility. And the first one we're going to look at is selling volatility. And this is referring to that volatility crush that David was referring to in the previous question. Which is, "What do you do if you expect that implied volatility that's high today is going to be at a lower value sometime in the future?"

(19:26):

For example, if let's say a stock currently has an implied volatility of 40% and you believe that sometime in the future that implied volatility is perhaps going to be half as much at 20%, how do you actually take advantage of that? And this is really where we're going to be looking at taking any type of option strategy that's going to give us negative Vega exposure. And what negative Vega exposure means is that it's an option contract that's going to generate profits if the implied volatility option is going to decrease in value. And generally speaking, any type of option strategy where you're selling an option. So if you're selling a call or selling a Put option or where the net strategy driver of an option is a short option, that's where you're going to have negative Vega exposure. And that's going to benefit if the implied volatility via an option goes from a higher level down to a lower level.

(20:26):

When we refer to selling volatility, we're referring to taking a position with an option contract that's going to benefit from the contraction of implied volatility from higher level to a lower level. And generally speaking, like I said, that will happen typically after some type of economic event or some type of earnings announcement comes by and the uncertainty factors removed and implied volatility will typically contract after that event itself.

(20:56):

And then conversely, on the flip side you could have a view that implied volatility is going to expand in the future. Now, we typically see implied volatility expand going into some type of economic event such as the U.S. election or the OMC meeting. We tend to see and implied volatility will slowly increase in value as we approach that event itself. And once the event happens, that's when we tend to see that volatility crush.

(21:26):

For example, if let's say you expect that implied volatility is going to expand going into an event. That's where you want to take an option position where you have positive Vega exposure, that's where you're going to be buying options that will generate profits if the implied volatility expands from the time that you buy it, to the time that you sell that option. And generally speaking, whenever you're buying an option or where the strategy driver of a complex strategy is a buy as long options, that's when you're going to have a position where you're going to have positive Vega exposure, that's going to benefit from an expansion in implied volatility.

(22:08):

Let's start reviewing some of the strategies, some of the advanced strategies and just giving you a better understanding of each one of these strategies and what type of exposure you're going to have to that implied volatility. And then at the same time understand what exposures that you're going to have, the other components that's going to affect the value of your option. We're going to look at the different degrees of exposure that you have to Vega, Delta and Theta and what that means for each of these specific scenarios. So the first one we're going to take a look at is a Bull Call Spread. And we've used this strategy before in one of our previous sessions on debit spreads. So what we're going to do is we're going to look at a bullish debit spread here and what that means with regards to your exposure to implied volatility and also your exposure to the other components.

(22:56):

So in this example here we're going to look at buying a 225, 230 call spread, a debit spread on Apple. So we're buying the 225 calls for, in this particular case, $7 and selling the 230 calls against that for $3.50 cents. Net net what you're paying is $3.50 cents for that spread. And that's why we call it a debit spread, because you're paying premium to enter this particular contract. Now, typically as we've discussed in previous sessions on debit spreads, you enter a debit spread when you expect the stock to rally. Typically, you expect it to rally fairly substantially to justify buying that debit spread. But what we didn't discuss in previous sessions is the fact that because the primary strategy driver of this strategy is a long option. Is that long 225 call option. Because you're long an option, you are going to have positive Vega exposure.

(23:57):

So this is going to be a strategy that benefits if the implied volatility option expands in value. So again, going into an economic event or going into a earnings event. This is where we typically see that expansion in implied volatility. This is a strategy that will benefit from that expansion in implied volatility. Now, we generally consider debit spreads as a strategy that gives you a medium amount of Vega exposure. It doesn't give you a lot of Vega exposure. That's certainly not a strategy, it gives you a little amount of Vega exposure. So, fairly medium positive Vega exposure that benefits from an expansion of implied volatility. But it also gives you Delta and Theta exposure. And in both cases I would say it gives you a medium amount of Delta and Vega exposure. In this particular case, because you're buying a bullish debit spread, it's going to give you medium positive Delta exposure, meaning this is the strategy that's going to be profitable if the value of the underlying increases in value versus decreasing in value would actually reduce the value of this debit spread.

(25:08):

But lastly, I think one of the things that you have to remember with a debit spread is that the primary strategy driver is a long option. And whenever you're long an option, you have negative Theta exposure. And what that means is that as time passes by that's going to decrease the value of your option. Now, you're going to offset that to some degree, because you're also sure that 230 call option. But you generally have, you're going to have negative Theta exposure, meaning time value is working against you. So, as you are holding onto this option, you are hoping that the stock is going to rally in price. And you're also hoping that an implied volatility is going to expand, but at the same time as you hold onto that time value is going to erode the value of that option each day you hold onto it.

(25:57):

So, that's something to consider when you're thinking about buying a debit spread is that you're going to get that positive Vega exposure, which is one of the few strategies that you can use if you expect an expansion in implied volatility but you have time value working against you. Which is one thing that you have to factor into when you're thinking about these types of strategies, because you don't want to hold onto this trade for too long. The longer you hold onto it, the more that time value is going to erode any potential benefits that the increase in the stocks value is going to have and the increase in expansion and implied volatility is going to have for this specific strategy.

David McGann (26:34):

Tony, I think this is a great example, and absolutely, I mean, we had a separate webinar where we went pretty deep on debit spreads. But as you mentioned, we didn't necessarily get into the nuances of Vega, Delta, Theta, in particular implied volatility. I think for options traders that have tried strategies like this and perhaps around an event like earnings, like you mentioned, Tony, right, have on some occasions at least been surprised where the price of the underlying has moved in the direction. So, let's say it's a bullish debit spread, has moved in the direction that they're expecting, but the option prices just really didn't move a great deal. And is that really a function then of that volatility crush where the weight of the Vega coming down offset, I guess the benefit or the lift in Delta? Is that really what's manifesting in that kind of a scenario?

Tony Zhang (27:32):

Yeah, that's exactly right. And I think most options traders have experienced this where they bought an option, maybe or call or a put, they saw that the stock moved in the direction that they expected to, yet at the end of the trade they either didn't turn a profit or potentially even lost some money on that specific trade and they're scratching their heads as to what happened. And generally speaking, those are the two components that worked against them. It's usually Vega and Theta that worked against them. So, you might have that Delta component working in your favor, but you had that perhaps a bit of a collapse and implied volatility which decreased the value of the option. And then you have a little bit of time that it went by that decreased the value of the option. And the combination of that Vega and Theta exposure effectively offset any gains that you might potentially have from Delta.