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Commodity Derivatives Management

Volatility
The vast majority of CDM Tradings investment strategies are based on volatility.
The word volatility comes from volare meaning to fly. Volatility in relation to options
refers to how much the price of the underlying asset flies about.
What is volatility and why is it so important to an option trader? The option trader,
like a trader in the underlying asset, is interested in the direction of the market. But
unlike the trader in the underlying, an option trader is extremely sensitive to the
volatility or speed of the market. Markets, which move slowly, are low volatility
markets; markets, which move quickly, are high volatility markets.
As you can imagine some markets are more volatile than others. Between 1980 and
1982, the price of gold moved from $300 per ounce to $800, more than doubling its
price. Few traders would predict that a major stock index might more than double in
a similar period. A commodity trader knows that precious metals are generally more
volatile than interest rate instruments. In the same way, a stock trader knows that
high-technology stocks tend to be more volatile than say utility stocks.
When traders discuss volatility, even experienced traders may find that they are not
always talking about the same thing. When a trader makes a comment that the
volatility of XYZ is trading at 20%, which volatility are they talking about? There are
several types of volatilities, future volatility, historical volatility, seasonal, forecast,
and implied.
However, the objective of the following information is to provide you with a basic
understanding of option volatility. The level of complexity has been kept low and the
amount of detail kept to a minimum. Therefore at this stage, we will cover the two
main types of volatility, and how it effects our trading strategy.

Historical Volatility
Historical volatility is associated with the underlying asset. We can talk about
the historical volatility of BHP, Gold, Crude Oil or the Aussie Dollar. It is a measure
of price movements over a period of time. It is obtained by taking the standard
deviation over the chosen period. If the time period used is 30 days for example,
calculate the squares for all the price percentage changes for each day, add them
together and divide by the number of days, and then find the square root.
The historical period may be ten days, six months or six years. The longer period will
give an average or characteristic volatility, while the shorter period may reveal
unusual extremes in volatility. It is essential that you become familiar with the
historical volatility of the underlying asset before trading it. Historical volatility is
seldom used alone in considering a strategy because different traders look at
different time periods, and who is to say which is right? One trader may look at 20
days, another at 60 days, and another may look at a year.

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Implied Volatility
Generally speaking, future, historical, and forecast volatility are associated with the
underlying contract. We can talk about the future volatility of the SPI Index, or the
historical volatility of the 3yr bond, or forecast volatility of the 10yr bond. In each
case we are talking about the volatility of the underlying contract.
Implied volatility is associated with the option itself. We measure how
expensive or cheap options are using a parameter called implied volatility. The term
implied volatility comes from the fact that options imply the volatility of their
underlying, just by their price. They use an option-pricing model (e.g. BlackScholes) backwards to arrive at the volatility from the price at which the option is
currently trading. Of the factors effecting option prices, all but one is known.
The trader knows the futures price, the exercise/strike price, interest rate, and
expiration date. The unknown factor is the volatility.
Lets say the S&P 500 Index futures are trading at 1,100 and the 1,120-call option
for 30 days is trading at 20.70 points. Using a volatility number of 30%, an optionpricing model produces a theoretical value of 16.50points. Obviously, the option is
trading at a higher volatility than 30%. In this example, the volatility is about 40%.
This says the market at this time is expecting or IMPLYING volatility to be around
40%.
Different strikes, puts and calls, and different times to expiration, all have their own
Implied volatilities.
Note: Implied volatility depends on the theoretical pricing model being used. For
some options, a different model can give a significantly different implied volatility.
The accuracy of an implied volatility also depends on the accuracy of inputs into the
model.

Trading with Volatility

Remember when trading options, one is basically trading volatility. The trader wants
to buy low volatility and sell high volatility, and different strikes have different
Implied volatility.
If you are considering buying a bull call spread and the strike you are buying has a
higher implied volatility than the strike you are selling, then the edge is against you.
If you are buying an option, you need to buy when implied volatility is lower than
"normal" or sell an option when it is significantly higher than "normal".
There are two ways of judging if the price of options is expensive or cheap. The first
is by simply comparing the current IV with past levels of IV on the same underlying
asset. The second is by comparing current IV with the volatility of the underlying
(historical volatility) itself. When options are expensive or cheap by both measures,
attractive trading opportunities may exist.

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High Volatility
When the options of a particular asset seem more expensive than usual, the
additional cost is usually justified by unusually high volatility in the underlying
(historical volatility). While this may look to be a good opportunity to sell options, it is
even more advantageous to sell options when the IV has moved higher than the
historical.
In this case, the edge is with the trader who sells this high volatility, and that means
selling options. Generally, any position in which you are short more options than you
are long is short volatility. The purest selling strategy is a naked strangle, which
involves selling both out-of-the-money puts and calls.
Out-of-the-money options are preferable in this particular strategy because it gives
the underlying some room to fluctuate, and increases the likelihood of realising a
profit. Generally, the farther out-of-the-money you go, the lower your returns, but the
greater the probability of achieving those returns. By giving the underlying room to
move, the trader minimizes his chances of having to make costly adjustments.
One other strategy for selling options is with a ratio spread. This position consists of
buying an option that is close-to-the-money and selling two or more options further
out-of-the-money.

Low Volatility
Low volatility situations can be just as lucrative. There are arguments against buying
options, based on the idea that time decay is against you. Time decay is a funny
concept. Do you remember using 'imaginary numbers' in math class to deal with
square roots of negative numbers? Time decay (or theta) is similar. It is an
imaginary number. It says that if the underlying asset's price holds perfectly still, the
option will decay at a certain rate as time passes. But what underlying asset price
holds still? None. In fact time is what gives the asset freedom to move.
There is nothing wrong with buying options. When an option is fairly valued, then by
definition, there is no advantage to the buyer or the seller. If you buy a fairly valued
option, you have not taken on a latent disadvantage in the form of time decay, why?
Because the underlying is constantly moving.
When buying options, it makes more sense to buy near-the-money, although it
doesn't have to be a pure straddle (call and put at the same strike). That way a
sharp move in the underlying has a better chance of helping the position. When the
move happens not only does IV normally get a boost, but also the move will drive
one of the sides deep in-the-money and give you a gain just from price movement.
Of course, this awaited price move might not happen immediately, thats why it will
pay to only buy options with plenty of time. You might even say that time is on our
side.
It is interesting that long volatility positions have a completely different feel to short
volatility positions. Short volatility positions often please the holder with steady,
almost daily, gains, but can suddenly loose money, if the underlying makes a sharp
move. Whereas long volatility positions seem to slowly loose value day by day for
many weeks, and suddenly gain very quickly. Despite the opposite psychological
effects, a mix of both types of positions belongs in the volatility traders portfolio.

Deciding when to close a long volatility position is usually more difficult, since the
position will move quickly into profit with a sharp move in the underlying, and has
probably become imbalance. Often there is the potential to make (or lose) more
money with each additional day that you hold the position. What can help you make
a decision is to identify whether volatility has returned to normal levels. If it has, you
should consider closing the position. If it has not, you might consider continuing with
an adjusted (re-balanced) position.
Finally, the concepts of option volatility, along with the time decay characteristic of
options, are two important and often overlooked factors in option trading. These
concepts can be difficult to learn and use, but the proper use of these option
characteristics can result in a trading edge over the markets.
For more information, please contact Guy Bower on (02) 9386 4561 or gb@cdmtrading.com.au.

Futures and options trading involves risk of loss and past performance does not guarantee future results.
Any information implied or contained within this document has not been prepared taking into account the
investment objectives, financial situation and needs of any particular investor. Investors using the
information should assess whether it is appropriate in light of their own circumstances before acting on
the advice. CDM Trading Pty Ltd 077412027