Hi, and welcome to an installment on demystifying volatility trading. Writing this piece was like traversing Sarah Winchester's Mystery House, trying to get to a particular room. A few staircases up and down, in-and-out doors, and through windows. But I got there. If you are not familiar with the house, check it out, it's at least as fascinating as volatility trading.
So here it is: if I buy an option, I buy volatility, and if I sell an option, I sell volatility. With a big caveat: I am delta hedged.
If you continually buy and sell USD to the expiry date, your option premium does not change when spot/forward changes, and you are delta hedged.
Today we will consider a 1-month 17.10 strike USD put option in USD10,000,000.
The put option buyer has the right to sell USD10,000,000 at 17.10 in 1 month and receive ZAR171,000,000* in return. For this right, the buyer will pay an option premium of ZAR2,753,000.
*10,000,000 x 17.10
Before I go on, I need to clarify what volatility is. If you have read any text on options, you would have encountered one of two terms: historical volatility and implied volatility.
Historic volatility describes the size of USDZAR price movements for some historical period – there are endless possibilities of measurement, for example:
- What was the size (daily low to high) of USDZAR over the last month
- What was the size (hourly low to high) of USDZAR over the last month
- What was the size (2-hourly low to high) of USDZAR over the last month
You go back in time and measure the price movements of USDZAR for a given timeframe over a given period. You also make assumptions about excluding weekends and public holidays from your calculation. Any of the above measurements could describe how volatile USDZAR was.
The current 1m atm volatility is trading in the market at 15.3%. The 15.3% is called implied volatility. Given the past price movements, current market conditions, and anticipated events, the market expects volatility of 15.3% to realise over the next month. By using 15.3% in your pricing formula, paying the resultant premium, and also perfectly hedging your delta to term, you are expected to break even. The market movements are expected to be just large enough to recoup your premium.
And we know that markets don't work like that, so here is where your "view" enters.
Are USDZAR vols too low? Buy an option. Buy volatility. Pay an option premium. Your crystal ball (also known as fantastic trading instincts and marvellous knowledge) told you the movement in USDZAR will be more significant, and your constant delta hedging of buying and selling USD (delta hedging) will afford you a profit more considerable than the premium you paid.
Say I bought this USD put option for ZAR2,753,000. The option has 50% delta, so the premium will change as if I were short USD5,000,000 (delta), so I start delta hedging:
Delta trade 1: I buy USD5,000,000 at 17.1000.
Now with all market inputs the same, I am delta hedged and no longer sensitive to spot/forward prices.
Example 1: Blow-out
I read the tea-leaves right when I realised that volatility was too low, and an unexpected event caused USDZAR to blow out to 19.50.
My 17.10 strike option is now so far out-the-money that delta is 0%.
Since I bought USD5,000,000 to hedge my option, and the delta changed from 50% to 0%, I need to sell USD5,000,000 to stay delta hedged.
Delta trade 1: I buy USD5,000,000 at 17.1000.
Delta trade 2: I sell USD5,000,000 at 19.5000
I made ZAR12,000,000** delta hedging.
**5,000,000 x (19.50 – 17.10)
If I subtract the premium, it means a profit of ZAR9,247,000. I can now unwind my option or keep delta hedging.
What is extraordinary here is that you made money on a far-out-of-the-money put option. The magic is that not only was the option never exercised, but it was so far out of the money that it became worthless, and you still profited!
Example 2: Greater than expected intra-day moves
I stumbled upon Sarah's Seance Room. My psychic abilities remained intact, and I rightly was told that volatility was too low. USDZAR traded 50cents up and down each day over the first four days. Nevertheless, I managed to capture 30cents each day.
Delta trade 1: I buy USD5,000,000 at 17.10
Delta trade 2: I buy USD2,900,000*** at 16.80 (overall I’ve bought USD8,600,000 at average 16.9898)
Delta trade 3: I sell USD2,900,000 at 17.10 (overall I’ve bought USD5,000,000 at average 16.9260)
Delta trade 4: I sell USD3,000,000**** at 17.40 (overall I’ve bought USD2,000,000 at average 16.2150)
Delta trade 5: I sell USD1,500,000 at 17.70, (overall I’ve bought USD500,000 at average 11.7600)
***As the market traded from 17.10 to 16.80, the delta changed from 50% to 79%*. So I needed to be long USD7,900,000 to be hedged or buy an additional USD2,900,000.
****At 17.40, the option had a delta of 20%. So I need to be long USD2,000,000 to be hedged or sell USD3,000,000 of my current USD5,000,000 long position.
Each time I buy or sell USD, I lock in a little bit of profit, and the average price of my delta hedge improves.
If I decided to unwind the option, I would need to sell the USD500,000 at 17.70. So I have made ZAR2,970,000***** on delta hedging. If I subtract the premium, I make a profit of ZAR217,000 over four days. Simply thrilling.
*****500,000 x (17.70 – 11.76)
In summary, to trade volatility, it matters not if you trade a put or call, whether the market goes up or down or in circles like Mrs. Winchester's staircases. If the movements are large enough and you delta hedge well, you can make a profit. What a marvel!