What options traders mean when they say they are ‘buying volatility’

Institutional options traders frequently refer to “buying” or “selling” volatility, but what does this mean? Is this something individual self-directed investors can do? Buying volatility refers to a trading strategy seeking to profit from an expected increase in the price fluctuation of the underlying security, market index or futures. An investor purchases financial instruments that benefit from higher volatility to accomplish this. Selling volatility is the inverse of this. Here are a few common ways to “buy volatility”: Institutional traders have access to an array of “over the counter” derivatives, many of which simplify the task, such as variance swaps. These allow investors to trade future realized volatility against current implied volatility. A buyer of a variance swap pays the “implied volatility” – consider this to be the market’s current expectation for future volatility over some predetermined period, in return for receiving the “realized volatility”. A variance swap buyer will profit if realized volatility exceeds implied volatility, and a seller will profit if implied volatility exceeds realized. Swaps provide an intuitive and simple solution to take on specific types of market exposure. Still, because these are individual contracts between two financial counterparties, unfortunately, they are available only to larger institutions. Another common way to trade volatility on the S & P 500 is through VIX futures and options: The VIX Index itself, sometimes referred to as the “fear gauge,” measures the market’s expectation, as implied by options prices on the S & P 500 Index, of future volatility. Traders can buy VIX futures contracts or options on VIX futures to profit from anticipated increases in market volatility, but cannot purchase the VIX Index itself. The challenge for investors trading these instruments though is that, unlike a variance swap, traders are not betting on the difference between the market’s expectation and what takes place, they are simply betting on changes in the market’s expectation for volatility. To illustrate this consider the following chart: A couple things should stand out to us immediately. The first is that a VIX future is not as reactive to changes in the VIX Index as one might expect. Notice for example that from late March to mid April the VIX Index (in blue) rose from 12.78 to 19.23. The August VIX future meanwhile rose from 17.35 to 18.85 over the same time frame. A trader expecting to profit from a sharp increase in the VIX would have seen only a modest profit during that two week time frame. There are two other very important takeaways here. The VIX Index closed at 13.20 on the first trading day of the year and is 13.75 as I write this. Meanwhile the August VIX future settled at 18.25 on January 2nd, the first trading of the year and is presently 15.45. So while the VIX Index is marginally higher over this time frame, a buyer of the future would see mark-to-market losses of $2,800 at this moment (each VIX futures contract has a 1,000 multiplier, so the current price of 15.45 – the Jan 2nd price of 18.25 = (2.80) x 1,000 = ($2,800). The other important takeaway is that “realized” volatility – how volatile the S & P has been over this period has been consistently lower than the VIX Index implied it would be. This phenomenon is common. The tendency for options prices to price in higher volatility than typically occurs is frequently referred to as the “volatility risk premium”. This is one of the reasons that always owning puts on a broad-market proxy as a form of portfolio insurance is not a winning strategy over time (the other reason is that the market generally rises over time). If options are generally implying more volatility than actually takes place does this mean that one should never buy options? Absolutely not. What it means is that purchasing options to make directional trades should be tactical, whereas selling options – such as in covered call strategies – should be systematic. So what does it mean to be “tactical” in practice? While it’s fine to believe that a stock is underpriced and will rise, that is only one part of the equation. The other part is identifying a potential catalyst, an event where investors are likely to learn new information, information that will cause them to buy or sell and thus move the price. Identifying specific catalysts – other than broad economic announcements such as inflation data or FOMC notes, is generally easier for single-stocks than for the broad market overall. A Snowflake trade Goldman Sachs derivatives strategists recently recommended buying calls in Snowflake Inc. (SNOW) . The Bozeman, Montana-based software company develops database architecture, data warehouses and query optimization, and parallelization solutions and naturally investors are interested to better understand the implications of AI investments for the company, and they likely will gain new insights when the company hosts their Data Cloud Summit 24 in San Francisco next week, June 3rd through June 6th. Goldman recommended the June 7th $152.5 calls, however the stock is actually lower since they made that recommendation. Moreover although I’m not a “chartist” or technical analyst, it is hard for me to identify anything particularly compelling here. That said, if an upside move is warranted, next week’s summit could provide the catalyst. A slightly higher probability bet than simply buying the weekly $152.5 calls would be to purchase a closer to at-the-money call vertical, such as the 145/152.5 call spread which cost about $2.50/contract as I write this. I’ve added a payoff graph to the price chart here to see where the trade would show profit or loss. DISCLOSURES: (None) THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.