Options Theory: How to Make a Pure Volatility Bet Part 1

Hello, friends. I hope you’re enjoying our new Options Theory blog! In our third installment we are going to focus on how to sidestep direction and bet instead on volatility. In Derivatives and the 3D’s, we introduced the three primary variables of interest to options traders. Namely, direction, speed, and magnitude. The latter two can be expressed by saying “how fast” and “how far.” Today I’d like to focus on how options traders make bets on how far a stock moves, irrespective of direction. Wagers like these fall under a category of trades known as volatility strategies.

Fundamentally, there are two types of volatility trades. Those that profit if the stock moves more than expected. And those that profit if the stock moves less than expected. The former group consists of strategies like long straddles, strangles, inverted butterflies, and debit condors (aka debicons). The latter group includes strategies like short straddles, strangles, butterflies, and iron condors.

Delta Neutrality

Let’s use the greek delta to help illustrate how a pure volatility bet would work. If you don’t already have a working understanding of the options greeks then run, don’t walk, to the Options 101 video series. You’ll learn all about them in Module 4.

Delta measures an option’s sensitivity to stock movement (direction). The higher your position’s delta, the more exposure you have to movement in the stock price. And the lower your position’s delta, the less exposure you have to movement.

Is it possible to not have any exposure to a stock’s price movement? In other words, is it possible to sidestep directional bets altogether? You betcha! That’s the whole premise of today’s piece. Haven’t you been paying attention?

To accomplish this, you simply need to trade what are known as “delta neutral” strategies. They are neutral because the delta is zero.

Let’s focus first on the volatility trades that profit if the stock moves more than expected. These are known as long volatility trades because you want volatility to increase. Next time we’ll look at short volatility plays.

Suppose we have a stock trading for $100 and we think it’s poised for a big move, but we don’t know in which direction. And it’s not just that we believe that it’s going to move. We believe the stock will move more than expected. That’s the key! To capitalize, we could enter a long straddle trade by purchasing an at-the-money call, and an at-the-money put. Suppose they cost $3 apiece or $6 total. To at least break even we need the stock to rise or fall by $6. That means our upside expiration breakeven price is $106 and our downside breakeven is $94.

Think about that for a second. The value of the straddle tells us what the market is expecting, what it is pricing-in. In this case, we’re talking $6. So, the only reason you would want to buy the straddle is if you think the stock has the mustard to move more than $6. If based on your analysis you believe that this $100 stock could pop to $110 or drop to $90 by expiration, then buying the straddle for $6 is a good bet.

Volatility Visualization

I visualize this situation like so.

Since the range I expect is larger than what the straddle is pricing in (i.e., what the market expects), I want to be a volatility buyer. That is, I want to go long volatility!

To further illustrate how this is a pure volatility bet we can look at the greeks of the position. We’ll focus on delta and vega since those are the two relevant to today’s discussion.

Since both the call and the put are at-the-money options, they carry deltas of 50. But while the call delta is positive, the put delta is negative. If you add them together you discover the net delta is zero ((+50) + (-50) = 0). That means it doesn’t matter if the stock rises or falls. Either way, your position won’t be impacted (at least initially) because the delta is zero. If the stock lifts $1, the call will gain $50, but the put will lose $50. And if we fall the put will gain $50 but the call will lose $50.

Got it?

Meanwhile the vega of both the call and put are positive so you will have exposure to volatility (that’s what vega measures). Suppose your net delta is zero, but your net vega is 40.

Were we to really go down the rabbit hole, we could discuss how the delta doesn’t remain neutral if the stock rises or falls, but I suspect I’d risk losing some readers at that point. Let’s summarize the key takeaways.

It’s possible to make a bet on how much the market will or won’t move using volatility trades.

The common characteristic among these trades is they start out delta neutral.

Trader anticipating the market will move more than expected go long volatility.

Traders anticipating the market will move less than expected go short volatility.

Next time we’ll take a look at a short volatility example.

Tyler Craig

You can find more about Options Theory at www.tackletrading.com