HOW TO MAKE MONEY FROM A CHANGE IN VOLATILITY
Volatility Trading Strategies In this chapter, I will discuss what may be the most creative of the options strate- gies, volatility trades. As previously explained, volatility is essentially the risk as- pect of the market. It is the perception of risk that is "securitised" 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. As I mentioned in Chapter 4, there are three ways to measure volatility. One method is the historical basis which measures what has happened in the past and is expressed as the annualised standard deviation of percentage changes in the underlying asset.
The second method is the implied volatility which is the current volatility associ- ated with the option's price. Finally, there is the method of volatility estimation which forecasts future volatility by using econometric techniques which incorpo- rate both the historical and implied techniques. Traders buy or sell volatility as their perception of future risk in the future changes. When market makers get more "edgy", they buy up volatility and when they expect stability, volatility goes down. So, the current determination of volatil- ity is simply the supply and demand for risk and this is reflected in the fluctuations in the prices of options. In this chapter, I will use the option on coffee futures traded at the Coffee Sugar and Cocoa Exchange (CSCE). The prices are in US Dollars and Table 7.1 outlines the contract specification for this underlying. The asset underlying the option is a CSCE Coffee futures contract which is the obligation to either buy or sell 37,500 pounds of Coffee beans.
HOW TO MAKE MONEY FROM A CHANGE IN VOLATILITY
How can someone make money from a change in risk? In an earlier chapter, I pro- vided an example of risk trading with the story about the fellow who bought insur- ance and was later (incorrectly) diagnosed as having a terminal disease. Because the value of the health insurance increased dramatically, the policy holder sold it back to the insurance agent and made a profit. l Then, when he was diagnosed cor- rectly, as not having a terminal disease, he was able to repurchase his health insur- ance at a low price once again. The insurance buyer had purchased low risk and then sold higher risk, to make money. The higher the perception of risk, the greater the value of the insurance. As risk recedes, insurance premiums and options prices both drop in value. So, if you expect risk to increase, you will buy risk and if you expect risk to fall, you sell risk. In this section, I will examine how to both buy and sell risk using volatility trading strategies.