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Option Volatility and Pricing Strategies

The price of an option is decided by seven elements or variables. Six of these seven variables have known values, and their input values into an option pricing model are clear. However, because the seventh component, volatility, is merely an estimate, it is the most crucial factor in deciding an option's pricing.

Factors that Decide Option Price

  • Volatility
  • The current price of the underlying
  • Type of option (Call or Put)
  • Time to the expiration of the option
  • Risk-free interest rate
  • Dividends on the underlying
  • Strike price

Options Volatility Trading Strategies

All other factors have known values except volatility. As a result, estimating the impact of these factors on option prices becomes simple. Volatility, on the other hand, is a variable with no fixed value. As a result, learning about option volatility and pricing strategies becomes vital. You presumably learned about the Greek options Delta, Gamma, Theta, Vega, and Rho when you first learned about options, and then you honed up on Delta. This is because many of the most generally taught options techniques are mostly based on the underlying price and direction.

However, if you only look at price changes, you may be losing out. Implied volatility can help you build trades with more flexibility and precision. It can assist you in developing strategies and identifying trade opportunities that go beyond price movement. As a result, we've created a blog dedicated to options volatility and pricing tactics.

Volatility trading is a measure of how much an option's price changes over time. Before we get into what volatility trading is, let's first examine historical and implied volatility. Volatility is calculated on an annual basis and is represented in percentage terms. Historical volatility (HV) is a measure of the underlying price movements over time, particularly the previous month or year. The riskier the options are, the higher the historical volatility. Implied volatility (IV) refers to the level of underlying volatility implied by the current option price. The projected volatility of a stock over the option's life is known as implied volatility.

The option price is lower than the implied volatility because lower volatility options do not predict higher price changes. As a result, when it comes to option volatility and pricing techniques, implied volatility is more relevant than historical volatility. Option traders should be aware of How to buy or sell options using implied volatility.

Option Volatility and Pricing Strategies

In order to plan a trade around IV, the market recognizes five proven option volatility and price methodologies.

1) Naked Call and Put Strategy

Although the most straightforward technique to follow, it is only for experienced traders. If your forecasts are incorrect, you will lose a limitless amount of money.

You sell an out-of-the-money put option when the underlying price is bullish, but you foresee substantial volatility. It is most effective when market sentiment is somewhere between bullish and neutral. Similarly, if a trader believes the market will remain bearish, he can write a naked call. When the underlying price declines, he sells an out-of-the-money call option and profits.

However, one word of caution: writing naked call or put has limitless risk, and if your strategy doesn't fit the trend, you might end up with a massive loss. Traders often enter into a spread by adding a short put/call position to the contract to hedge against risk exposure.

2) Short Strangle and Straddle

Short Strangle and Straddle: In a straddle contract, a trader writes (sells) both call and put options at the same strike price in order to get premiums from both. He anticipates IV to fall near expiration, allowing him to keep the premium from both options.

A short straddle condition is similar to a short strangle approach. Strike prices of call and put options do not remain the same in a strangle situation. According to the thumb rule, the call strike price will always be higher than the put strike price.

The profit potential of a strangle is lower than that of a straddle, but it gives you a wider range to limit risk.

3) Iron Condors

The iron condor is a good alternative if you like the notion of short strangle but don't want to take the risk. It entails trading a pair of out-of-the-money spreads on the call and put sides to improve profit potential while reducing risk volume.

4) Ratio Writing

Ratio writing occurs when a trader writes more options than are purchased. A 2:1 ratio is used in the simple ratio writing approach, with two options sold or written for every option purchased. The idea is to profit from a significant drop in implied volatility before the options expire.

Option Volatility and Pricing Strategies - FAQs

Q1. What are option volatility and pricing?

Option Volatility & Pricing teaches you how to employ a number of trading techniques and how to select the one that best suits your perspective on market conditions and risk tolerance.

Q2. How is option volatility calculated?

Volatility is expressed as an annualized number in the options world. By multiplying the volatility by the underlying price, you may determine a one-year, one-standard-deviation shift.

Q3. What is the greatest option strategy for high volatility?

  • The strangle options strategy is intended to profit from market volatility.
  • A long strangle is formed by purchasing both a call and a put option for the same underlying share and expiration date - but with different exercise prices.
  • This method may have an endless profit potential while posing a low risk of losing money.

Q4. Is excessive volatility beneficial to option traders?

Options with significant implied volatility will have high option premiums. Inversely, implied volatility decreases when market expectations decrease or demand an option declines. Option pricing would be lower if the implied volatility of the options is lower.

Q5. Should you invest in high-IV options?

Traders might use high implied volatility to help them decide whether to buy or sell option premiums. It also shows us how the market expects the stock price to change over the course of a year. A high IV indicates that the stock may be more volatile than similar low IV stocks.

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