Volatility Trading Strategies

Professor Menelaos Karanasos

Abstract

Volatility is essentially the risk aspect of the market. It is the perception of risk that is “securitized”in the time value component of an option premium. The volatility can be implied in the options price (which includes traders’expectations of future price movements) or be based upon the actual ‡fluctuations in the price of the asset which underlies the option. Traders buy or sell volatility as their perception of risk in the future changes.

The ideal way to trade volatility is to maximize the exposure to both kinds of volatility (actual and implied) and minimize the exposure to the other factors which influence option prices, such as small movements in the underlying market and if possible time decay. This is done by using the “Greeks” to assess the exposure the trading strategy has to all the variables which drive option prices. To bene t from a change in actual volatility of the market, the trader will want to establish a gamma positive or negative position. To benefit from a change in implied volatility, the trader will focus on her kappa (vega) exposures. For the other derivatives such as delta, theta, and rho, she will try to minimize her exposure to these Greeks by driving their level to zero.

By doing so, the trader can focus her viewpoint on volatility alone. When one is completely neutral to the underlying market and is just trading volatility, it is termed pure volatility trading. In addition to pure volatility trading one can establish trading strategies that are initially neutral to the underlying market but can become an equivalent long or short position as the underlying market price moves to a particular level. These trades are usually called leaning volatility trades.


Professor Menelaos Karanasos' complete article can be found here.

Disclosure

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