At DEGIRO, we believe it is important that you invest with sufficient knowledge. Furthermore, we would like to make sure that you trade financial instruments that suit your needs and objectives. This article explains what volatility options are and how you can trade them.
One of the variables that determines the price of an option, is volatility. Volatility is described as a statistical measurement of the degree of fluctuation in price of a market or security. This factor is uncertain and cannot be determined when buying a financial product. The world of investing knows two types of volatility, historical and implied. The latter is the level of volatility of the underlying, which is implied by the current option price. The implied volatility can be described as a prediction made by market participants on the degree to which underlying securities move in a specific timespan in the future. This kind of volatility is based on real-time price measurement. Volatility can be calculated by using formulas that measure option market expectations.
Historical volatility, also known as statistical volatility, measures how fast the price of the underlying product changes over a given time period. A higher historical volatility percentage will lead to a higher value of the option. Historical volatility is usually calculated on an annual basis. However, due to the fact that prices are constantly changing, for options held over shorter time frames the historical volatility can be calculated on a daily basis. The time period is an essential factor for investors. The time to expiration, for example, is one of the factors that can affect the price of a volatility option. Also, the value of the underlying volatility index has an effect on the option price.
Volatility options are a type of option with a volatility index as the underlying factor. A volatility index represents the market's expectation of volatility in financial markets (for example the stock market) over a certain period of time in the future. Examples of volatility indices are the VIX or VSTOXX.
Volatility options are generally considered suitable for investors who can bear the loss of capital and have sufficient knowledge with similar financial instruments. You can find the risk indicator of a specific product in the Key Investor Document (KID). This is a 3-page document that describes the characteristics of the product and the risks associated with the product. Information about contract specifications and the underlying can also usually be found on the exchange’s website.
Since volatility options are derivatives, you will find information on every option on the website of the derivatives exchange where the specific option is listed. For DEGIRO clients this can, for example, be Euronext Derivatives Amsterdam, Eurex, CBOE or CME.
When an option has an intrinsic value, that option is called "in the money". This is possible for both call options and put options. For example, call options are in-the-money when the exercise price is lower than the price of the underlying asset. The expression in-the-money is used when the strike price is lower than the market price. A put option is in the money when the exercise price is higher than the underlying value. If the opposite is true, the option is "out of the money."
Before investing in volatility options, the investor needs to be aware that they are settled in cash, so as a buyer of a volatility option you receive a cash settlement if the option is in-the-money at expiration. At DEGIRO this cash settlement will automatically be booked in your investment account.
Investing can be rewarding but it is not without risk. Like all other financial products, investing in volatility options comes with the risk of loss. If you have a short position in a volatility option, the maximum profit is the premium you received when selling the option. Selling an option can also be called “writing an option”. If you have a long position in a call option the maximum profit is theoretically unlimited. Always, in case of long position in a call option, the profit is unlimited, because price of underlying can theoretically increase without limits. If at expiry the volatility index is higher than the strike price of the price of a put option on this volatility index, the option will expire worthless. Call options on volatility can be used as a hedge for price declines in the market. Most overall market declines have been characterised by high volatility.
At DEGIRO, we are open and transparent about the risks that come with investing. Before you start to invest, there are a number of factors to consider. It helps to think about how much risk you are willing to take and which products match your knowledge. Additionally, it is not advisable to invest using money that you may need in the short term or to enter into positions that could cause financial difficulties. It all starts with thinking about what kind of investor you want to be. You can read more about the risks of investing in our Investors Services Information documents or our dedicated risk page.
We hope this article helped you to understand the key characteristics of volatility options. The information in this article is not written for advisory purposes, nor does it intend to recommend any investments. Investing involves risks. You can lose (a part of) your deposit. We advise you to only invest in financial products which match your knowledge and experience.