Strategies for generating profits from volatility may be developed using derivative contracts. Futures, volatility index options, strangle and straddle options positions, and volatility index options may all be utilized to benefit on volatility.
Straddle Approach
In a straddle strategy, a trader buys call and put options with the same maturity and strike price on the same underlying. The trader anticipates more volatility since the technique allows them to benefit when the underlying price changes direction.
Consider a trader who purchases a call and a put option on a stock with a $40 strike price and a three-month maturity period. Assume that the underlying’s stock price is at $40 as well. As a result, both options are trading at a profit. Imagine that the underlying price movement has a 20 percent yearly standard deviation and a 2 percent annual risk-free rate. We can calculate that the call price is $1.69 and the put price is $1.49 using the Black-Scholes model. (Put-call parity also forecasts that the call and put prices will be about $0.2) The total of the call and put prices—$3.18—represents the cost of the strategy. The approach enables a long position to benefit from any price movement, regardless of whether the underlying’s price is rising or falling. Here is how the volatility profit approach works in both price rise and price reduction scenarios:
The underlying price at maturity is more than $40 in Scenario 1. In this instance, the trader exercises the call option to realize the value after the put option expires worthless.
Situation 2: The underlying price is less than $40 when it reaches maturity. In this scenario, the trader exercises the put option to realize the value after the call option expires worthless.
The strategy’s cost, which is equal to the total of the premiums paid for the call and put options, must be high enough for the trader to make a profit. To reach a price of either more than $43.18 or less than $36.82, the trader requires volatility. Let’s say the cost goes up to $45. In this instance, the call option succeeds and the put option expires worthless: 45-40=5. We arrive at a net profit of 1.82 after deducting the position’s cost.
Strangle Strategy
Due to the employment of two at-the-money options, a long straddle position is expensive. By building straddle-like option positions utilizing out-of-the-money options, the cost of the position may be reduced. An out-of-the-money call plus an out-of-the-money put make up this position, known as a “strangle.” This technique will be cheaper than the straddle shown before since the options are out of the money.
A second trader may purchase a call option with a strike price of $42 and a put option with a strike price of $38 to continue the prior scenario. With all other factors being constant, the call option will cost $0.82, while the put option will cost $0.75. As a result, the position costs only $1.57, which is almost 49% less than the cost of the straddle position.
Despite the fact that this technique doesn’t need as much capital as the straddle, it does require more volatility to be profitable. The graph below shows this by measuring the length of the black arrow. This approach requires volatility to be strong enough to cause the price to go above $43.57 or below $36.43 in order to be profitable.
Using Options and Futures for the Volatility Index (VIX)
Futures and options on volatility indexes are direct trading instruments for volatility. The implied volatility, or VIX, is calculated using S&P500 option prices. Regardless of the direction of the underlying price, traders may benefit from changes in volatility using VIX options and futures. The Chicago Board Options Exchange is where these derivatives are exchanged (Cboe). The trader may purchase a VIX call option if they anticipate an increase in volatility and a VIX put option if they anticipate a drop in volatility.
Futures trading tactics for VIX will be the same as for any other underlying. If the trader anticipates an increase in volatility, they will take a long futures position, and if they anticipate a drop in volatility, they would take a short futures position.
Conclusion
At-the-money call and put options are used in the straddle position, while out-of-the-money call and put options are used in the strangle position. These may be built to take advantage of rising volatility. The Cboe’s Volatility Index options and futures enable traders to place direct bets on implied volatility, allowing them to profit from volatility changes in either direction.
