As an options’ volatility increases, vol premium doesn’t just go up too, it does so exponentially—much higher than vol increases would suggest.
You listen to the news. You hear that market volatility is higher than normal. Talking heads see volatility as a “fear gauge,” with the implication that it’s a tougher investor environment. You get it. Higher volatility (“vol”) can mean stock and index prices move a lot in various directions. It’s not easy when prices don’t rise or fall in a predictable way. It gets scary. And scary equals fear. So, volatility becomes a marker for fear. But consider these numbers.
For example, a stock price is $100, its vol is 15%, and the 95 put with 50 days to expiration has a theoretical value of $0.50. Likewise, a stock price is $100, its vol is 30%, and the 95 put with 50 days to expiration has a Black-Scholes theoretical value of $2.22. Same stock price, same strike price, same days to expiration.
But when vol is 2x higher, the option’s theoretical price, in this example, is more than 2x higher. In fact, it’s over 4x higher. You know that higher volatility can mean higher option prices, all things being equal. But option prices don’t increase in a linear way with higher vol. They increase exponentially because according to theory, an option’s “vega” (how much price changes with a change in vol) increases as volatility increases. So, higher vol means higher vega, which can mean greater increases in an option’s price as volatility increases.
In a practical way, higher vol suggests more uncertainty about how much the price of a stock could change. So, traders who want to buy downside protection in the form of a put have to pay up for that protection. It’s the same reason car insurance is higher for 18-year-olds than for those so-called old folks who statistically are safer drivers.
On the other hand, for example, in a margin account, let’s say the requirement for a short put is either 20% of the stock price minus the out-of-the-money amount, or 10% of the strike price, whichever is larger. Options volatility doesn’t have anything to do with it. And even though a broker may increase margin requirements in times of extreme volatility, the requirements don’t go up and down daily as volatility goes up and down. In this example, for a 95 put on a $100 stock, the requirement in a margin account would be $1,500.
Think of it this way: with $1,500 in capital, you can short the put in low vol and have a max theoretical profit of $50. Or short the put in high vol and have a max theoretical profit of $222. Also, the max risk if the stock goes to 0 is $9,450 when vol is 15%, and $9,278 when vol is 30%.
Rather than a “fear gauge,” volatility can also be an important “opportunity gauge.”
Naturally there’s no guarantee of making money when volatility is high, while higher volatility can, in fact, signal larger potential future price changes that could create bigger losses on a short put than with low vol.
But here’s the catch: big price changes when a stock, or the market broadly, gets surprised can happen at any time, whether vol is high or low. Yet, when volatility is higher, your potential reward and maximum risk are higher, too. So when everyone’s buzzing about the market going haywire and vol going through the roof, step back and think about these numbers. And decide for yourself whether it’s time to sit on your hands or get in a trade.