Ken Trester

Volatility: The Option Buyer's Secret Weapon

    Tweet This

A magic bullet, a panacea, a secret weapon -- these terms are used a lot in trading circles, and the idea behind each is basically the same.

Everyone is looking for the one trick that's going to lead them to the investment promised land. And while most of these tricks are just that -- tricks -- some secret weapons are legitimate profit-making tools.

Now, most options experts I know prefer to write options (i.e., they sell to open their options positions as opposed to buying them). Many of these experts claim that buying options is a sucker's game. This is partially true, but only partially.

Surprise Volatility

I admit that I love to write options, but when I do buy options I take advantage of that much-sought-after secret weapon. This secret weapon is what I call, "surprise volatility."

You see, when you buy options, you are betting on one thing -- volatility, or movement of the price of the underlying stock, index or exchange-traded fund (ETF). If the stock doesn't move much, then you lose.

Volatility is usually pretty predictable and moves in accordance with a log-normal curve, i.e., a bell curve. In fact, the Black-Scholes pricing model -- a Nobel Prize-winning instrument used for measuring the fair value of an option -- is based on this curve.

Volatility is the tendency of an underlying stock's price to fluctuate up or down. The higher the volatility of a stock, the greater the likelihood that a stock price change will move an option deeper into the in-the-money range (that is, if its strike price is lower than the market value of the underlying shares).

As volatility goes up, both call and put values spike. Likewise, as volatility drops, both call and put values drop.

The challenge in predicting volatility is that the markets do not always move in accordance with a log-normal curve. A principle called chaos theory -- which says that small occurrences significantly affect the outcomes of seemingly unrelated events -- throws a wrench in the bell curve theory. Stocks and even futures can make moves that are much larger than what this curve prescribes.