How Does Volatility Affect Options Pricing?

(Some options traders are often caught by surprise when their options were not making the intended profits even though they were right on the direction.

For example, when you buy a put option - you are expecting to make profits when the stock goes down.

You saw during pre-market, the stock was down by 3% - and you get excited expecting your put options to be making profits when the market opens.

But when the market open - it only gave you disappointment that you are making little to no profits even though you were right on the direction.

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(In some cases, you may even be losing money.)

I know exactly how it feels - because I have been through that before.

Some options traders are frustrated as they do not understand the intricacies behind option pricing, and give up on using options altogether.

​In this article, my goal is to

• Debunk the myths of options
• Why you are not making the intended profits
• How to avoid being in such positions
  
  

Options Gives Better Returns If You Are Right

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 Options are often thought as leverage instruments.

This means that if a stock moves up by 10% in share price - an option is expected to profit by around 20 - 30%.

It turned out that this is not always true.

To demonstrate this - I decide to show a back-test that I have done.

I tested this on Las Vegas Sand Corporation where I intend to put a bearish position on 20 Mar 2020.

I opened two bearish positions when the share price was at $46.90 and closed them when the share price fall to 43.44 - a drop of 7.3%.

(I will explain in a while why I chose these share prices.)

The goal of the back-test is to check if there were any significant difference between using options and simply shorting the stocks.

So the bearish positions taken were

1. Short Selling 100 LVS Shares
2. Buying At The Money Put Options (S.P 45) with 91 Days of Expiry

I took these positions using the ThinkorSwim Backtest Feature - OnDemand.

OnDemand essentially allows me to go back in time in exact seconds - that allows me to back-test these trades.

The common understanding is that options should have leveraged returns - so people would expect to get more than 7.3% return using put options.

Let's see how it goes.

In the back test, I took both of these trade at the same time.

I shorted 100 shares at $46.90 and at the same time, I bought a put option with a strike price of 45 and expiry of 91 days.

So now let's take a look what happens when the share price fell to $43.44 - which was 10 days later, on 30 March 2020.

What did we notice here?

The put option gave a P/L of -5.56% even though the share price moved in favour of a bearish position.

On the other hand, the short sell positions profited 7.38%, as expected.

(Note that we are only looking at the P/L% and not the absolute P/L)

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Why The Option Are Not Making Intended Profits?

Most people who are new to options have to understand this.

And it is called volatility.

Option pricing is affected by volatility as well.

To explain:

• An option price increase when volatility increases
• An option price drops when volatility decreases.

The amount the option prices dropped is determined by this term called Vega.

The Vega of an option measures the impact of changes in volatility of the underlying asset on the option price.

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So when you buy an option, no matter whether it is a call or a put, you are long on volatility - which means that volatility goes up, your options will make profits if all else stay the same.

And when you buy a put option, you make profits if the share price falls.

So what happened above?

Well, you guessed it right.

• Put Options made money from the dropped in share price.
• Put Options lost money from the drop in volatility

The result?

The profits and losses offset each other, therefore, the put option in the above example did not make any profits.

I won't go into details as to how the option pricing works - because they are affected by 6 factors:

Point 1 to 5 are pretty much known factors.

But Implied volatility is determined by the options market maker.

This is why implied volatility is so important.

So what was the implied volatility of the underlying asset on 20 March 2020 and 30 March 2020?

• 20 Mar 2020 - 188.51 %
• 30 Mar 2020 - 116.31 %

These values can be extracted using the ThinkorSwim Platform.

You can see that there is a drop in 72.2% in implied volatility.

Let's look at the Vega to understand how much loss was incurred due to this drop.

And what was the Vega at 20 Mar 2020 and 30 Mar 2020?

• 20 Mar 2020 - 8.25
• 30 Mar 2020 - 8.03

Notice that the Vega for the option has changed slightly due to the change in underlying asset.

Let's take the average Vega - 8.14.

So the total losses due to the drop on volatility alone was 8.14 x 72.2 = $587.71

This means that, had the implied volatility remained the same, the put option should have been making -$45 + $587.71 = $542.71.

(The -$45 is from the P/L from the image above.)

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So right now - you should be able to tell them volatility plays a huge role in options investing.

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But let's get to the important part - how do we avoid being in such positions where our options lose money even if we were right on the market direction?

How To Avoid Being In Such Positions

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Well, by now, you should realise how volatility can eat up our profits.

So how can we avoid being in such positions?

It is the simple logic of buy low and sell high.

We want to be buying options only when the volatility is relatively low.

How do we know if the volatility is low?

We can simply look at the volatility levels in the past.

This is the implied volatility for LVS.

Looking backwards - you will realise that the increased in volatility have cause options to become much more expensive.

And any drop from that heightened volatility will simply eat your profits.

So in short - avoid buying options at heightened volatility levels.

So what can you do instead?

Taking Advantage Of Volatility

You see - we want to avoid buying options when volatility are heightened.

So the opposite is true as well.

We would express our positions by selling options instead.

Why?

Because with increased volatility, option prices increases.

This means that we are collecting more premium when we sell options.

Another way is use synthetic long/short positions.

This is also called put-call parity.

An example of synthetic long will look like this:

• Buy Call at Strike Price of 50
• Sell Put at Strike Price of 50

The reason why this works even in high volatility environment is because even if the volatility were to drop - the sell put position will make profits and offset the volatility profit losses incurred by the call option.

In short, the combination of these two will have zero/very little Vega - and therefore not affected much by volatility change.

In most cases, this positions actually gives you credit upfront.

The above example shows that initiating a synthetic long position gives me a credit of $412.

This position is known as synthetic long because it provides a P/L diagram as if you are long 100 shares.

However - take note that there is a margin requirement for such positions.

Synthetic positions consumes your options buying power - and if your option buying power goes to negative due the movement in share prices - your broker may issue a margin call.

As always, learn to manage your risk.

The Bottom Line

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When you buy a put option - your profits can get eaten up by a drop in volatility due to Vega.

Don't buy options when volatility is high - sell options instead.

If you are more experience in investing - you can consider the synthetic positions to neutralize the Vega.

There are moments where options do give a marginal benefit compared to buying shares.

But you need to understand options before investing using options so that you use the appropriate strategy with respect to the situation..

The reason why I wrote this blog post is to help investors understand the risks of options and how to mitigate them.