What happens when volatility rises in front of big events?
Does this offer any opportunity?
How can one make money in this?
Let me iterate a scenario that often occurs around large known events like elections, budget(sometimes),mega-results.Option Pricing requires Implied volatility as input in Black-Scholes method and the output is Option price. While analysing data we see implied volatility and it’s behaviour to arrive over time to reach a conclusion for our trading. Below is a hypothetical scenario analysis worked out, let’s go through.
1) Underlying price = 10000(fixed for the purpose of illustration)
2) Exercise price = 10000(fixed, in real markets one should use closest liquid ATM strikes)
3) Days Until expiration = We’re assuming the event is in the middle of the month, so taking 4 scenarios of 30,25,20,15 days to expiry.
4) Interest rate & Dividend yields = assuming 0(using futures as underlying)
5) Volatility = here’s the catch, as we move near event date volatility will keep on increasing(probable scenario)
a) 30 Days to expiry – Volatility at 25 % and straddle value near 570
b) 25 Days to expiry – Volatility at 27.3 % and straddle value near 570
c) 20 Days to expiry – Volatility at 30.5 % and straddle value near 570
d) 15 Days to expiry – Volatility at 35.3 % and straddle value near 570
In all the cases straddle value remains same despite rise in implied volatility, so you don’t make money as a straddle buyer(but you don’t lose either on a time decaying asset).It presents a good opportunity to scalpers for couple of points. Knowing the straddle value will not lose a lot of value over a decent period is a big help/trade for option buyers/scalpers, however exit in this case is very important. Last 2 days into events it is again a call a trader/scalper has to take.
This is very specific type of trade, one should backtest intra-day data to see the efficacy of the trade.
Cherry on the cake – let’s assume i had to take position home as straddle didn’t move throughout the day. And the next day happened to be a trend day in markets along with your underlying, you will get more than expected points in the trade.
Downside – Whisper/leaked numbers may kill volatility before event also. Not all underlying are suitable for this type of trade.
Disclaimer – I am not a sebi registered advisor.Kindly consult your financial advisor before implementing.
Comments & Feedback are welcome.
Share this Post