Volatility Trading 101

8 min readFeb 8, 2023

What is Volatility Trading?

Volatility trading refers to trading the volatility of a financial instrument rather than trading its price. This allows one to increase the asset’s profit or bottom line without having to predict the direction of the market (or the market’s tendency). Volatility traders do not concern themselves with the direction of price moves, but rather only trade the volatility itself.

Volatility is an important statistical measure of market behavior and the most common risk measure in financial theory. In plain words, if the volatility rises for the same asset or index, it means that the market becomes unstable.

Before we dive deep into the different types of volatility trading strategies, let’s go over a couple of basic option trading terms:

Underlying Asset — In options trading, the underlying asset can be stocks, futures, index, commodities, or currency. The price of options is derived from their underlying asset. The option on the assets gives the right to buy or sell the stock at a specific price and date to the holder.

Expiration Date — In options trading, all stock options have an expiration date. The expiration date is also the last date on which the holder of the option can exercise the right to buy or sell the options that are in holding. In options Trading, the expiration of options can vary from weeks to months to years, depending upon the market and the regulations.

Strike Price — The strike price is the price at which the underlying asset can be bought or sold as per the contract. In options trading, the strike price for a call option indicates the price at which the asset can be bought on or before its expiration. For put options trading, Asset price refers to the price at which the seller of the underlying can exercise its right to sell the underlying assets (on or before its expiration).

Premium — Since the options themselves don’t have an underlying value, the options premium is the price you have to pay to purchase an option. The premium is determined by multiple factors, including the underlying stock price, volatility in the market, and the days until the option’s expiration. In options trading, choosing the premium is one of the most essential components.

Call option — A call option is an option contract that gives the buyer of the contract the right, but not the obligation, to purchase the underlying asset at the strike price on or before (depending on option type) the expiration date. The seller, or writer, of the call option, has an obligation to sell the underlying should the buyer of the contract choose to exercise his/her right to purchase the underlying.

Put option — Put option is a derivative instrument that gives the buyer of the option (holder) the right but not the obligation to sell the underlying asset at a fixed price (strike price) after a specified period of time.

The seller of the put option (put writer) has a contingent obligation to purchase the underlying asset if the put holder wishes to exercise the option. As the option gives the buyer a choice to exercise the option or not, the seller charges a fixed upfront fee from the buyer (known as a premium).

X- current value of the underlying asset

In the money — when it would be profitable to exercise

For a call: when asset market value > strike

For a put: when asset market value < strike

Out of the money — when it would not be profitable to exercise

At the money — when asset value = strike price

There are many tools that traders can use to trade volatility. In this article we will go over the main 3 strategies and their advantages and disadvantages:

Long straddle
Long strangle
Volatility Index

Long straddles and long strangles are often compared to Implied volatility investment products, And traders frequently debate which the “better” strategy is, but Neither strategy is “better” in an absolute sense. There are tradeoffs. Let’s try to understand the different strategies and which one is more suitable to which trader:

Long straddle

A long straddle options strategy involves buying both a call option and a put option with the same strike price (K) and expiration date (t) This strategy profits if the underlying asset’s price moves significantly in either direction, but it also incurs the most risk.

Example, Where:

K =50, is strike price

P =10, is Call & Put option premiums

Sₜ is the asset price at expiration

PnL is the profit or lost for Long Straddle

Long strangle

A long strangle options strategy is similar to a long straddle, but the strike prices for the call and put options are different. This strategy also profits if the underlying asset’s price moves significantly in either direction, but it is less risky than a long straddle because the strike prices are farther away from the current price of the underlying asset.

Example, Where:

K₁ =40

K₂ =60

P =5, is Call & Put option premiums

Sₜ is the asset price at expiration

PnL is the profit or lost for Long Strangle

Long straddles involve buying a call and put with the same strike price. Long strangles, however, involve buying a call with a higher strike price and buying a put with a lower strike price.

There are three advantages and two disadvantages of a long straddle:

The first advantage is that the breakeven points are closer together for a straddle than for a comparable strangle. Second, there is less of a change of losing 100% of the cost of a straddle if it is held to expiration. Third, long straddles are less sensitive to time decay than long strangles. Thus, when there is little or no stock price movement, a long straddle will experience a lower percentage loss over a given time period than a comparable strangle.

The first disadvantage of a long straddle is that the cost and maximum risk of one straddle (one call and one put) are greater than for one strangle. Second, for a given amount of capital, fewer straddles can be purchased.

Volatility Index

Most of us have heard of the “Market fear” index in the stock market, the index that is sometimes referred to as the “Market Fear Index”, measuring the implied market volatility and a counter index to the standard financial indexes that track upwards market movements.

Implied Volatility (IV)

The term implied volatility refers to a metric that captures the market’s view of the likelihood of changes in a given asset price. It is a metric used by investors to estimate future fluctuations (volatility) of an asset’s price based on certain predictive factors.

Implied volatility isn’t the same as historical volatility (also known as realized volatility or statistical volatility), which measures past market changes and their actual results.

Just as with the market as a whole, implied volatility is subject to unpredictable changes. Supply and demand are major determining factors for implied volatility. When an asset is in high demand, the price tends to rise. So does the implied volatility, which leads to a higher option premium due to the risky nature of the option.

The opposite is also true. When there is plenty of supply but not enough market demand, the implied volatility falls, and the option price becomes cheaper.

Volatility smile

A volatility smile is a geographical pattern of implied volatility for a series of options that has the same expiration date. When plotted against strike prices, these implied volatilities can create a line that slopes upward on either end; hence the term “smile.” Volatility smiles should never occur based on standard Black-Scholes option theory, which normally requires a completely flat volatility curve

The volatility smile is not predicted by the Black-Scholes model, which is one of the main formulas used to price options and other derivatives. The Black-Scholes model predicts that the implied volatility curve is flat when plotted against varying strike prices. Based on the model, it would be expected that the implied volatility would be the same for all options expiring on the same date with the same underlying asset, regardless of the strike price. Yet, in the real world, this is not the case.

The volatility smile is one model that an option may align with, but implied volatility could align more with a reverse or forward skew/smirk.

The Difference Between a Volatility Smile and a Volatility Skew/Smirk

While near-term equity options and forex options lean more toward aligning with a volatility smile, index options and long-term equity options tend to align more with a volatility skew. The skew/smirk shows that implied volatility may be higher for “In The Money” or “Out The Money” options.

Reverse Skew (Volatility Smirk)

Options pricing models assume that the implied volatility (IV) of an option for the same underlying and expiration should be identical, regardless of the strike price. However, option traders discovered that in reality, people were willing to “overpay” for downside striked options on stocks. This meant that people were assigning relatively more volatility to the downside than to the upside, a possible indicator that downside protection was more valuable than upside speculation in the options market.

In the reverse skew pattern, the IV for options at the lower strikes are higher than the IV at higher strikes. The reverse skew pattern suggests that in-the-money calls and out-of-the-money puts are more expensive compared to out-of-the-money calls and in-the-money puts.

Forward Skew

The other variant of the volatility smirk is the forward skew. In the forward skew pattern, the Implied volatility for options at the lower strikes are lower than the Implied volatility at higher strikes. This suggests that out-of-the-money calls and in-the-money puts are in greater demand compared to in-the-money calls and out-of-the-money puts.