How tied options work as volatility trades
By Simon Gleadall, CEO of Volcube.
When traders learn the basics of options trading they tend to learn about ‘naked’ options. This means options on their own. Options without any kind of associated delta hedge. But in practice, and especially in the professional derivatives markets, a huge amount of the options volume involves ‘tied options’ trades. Tied options are also commonly referred to as ‘volatility traded’ or ‘vol trades’ or options traded ‘as a vol’ (short for ‘as a vol trade’). Options as vol trades means options that are accompanied by a trade in the underlying product which serves as a delta-hedge. Let’s look at a simple example
A simple example of a tied option/vol trade strategy
Suppose the spot is trading at $100.20 and we are interested in the $101 strike calls. Let’s suppose that these options have a contract multiplier of 1 (ie one option gives its owner the right to trade one contract of the underlying spot). Let’s also suppose the calls have a 40% delta.
The market might quote these as the ‘$101 calls versus $100.20 with a 40% delta”. This means that if someone trades this strategy they won’t just trade the 101 calls. Rather, they will trade the 101 calls AND they will trade the spot at a price of $100.20. More specifically, suppose we buy 500 lots of the $101 calls tied against $100.20 with a 40% delta. In this case, as part of the package of trading the $101 calls ‘as a vol’ we will also be selling 200 lots of the spot at $100.20. Why 200 lots? Because the calls have a 40% delta and we bought 500 calls; 40% of 500 = 200. Why selling? Because the calls (which we bought remember) have a positive delta and the point of the accompanying spot trade is to delta hedge the calls. So the package must include a sale of the spot to delta-hedge the long calls. Why at a price of $100.20? Because this was the reference price for the volatility trade.
You can see another good example in this Volcube Pro Edition video which shows how vol trades are handled in Volcube. Volcube Starter Edition also includes volatility trades so feel free to sign up for the free trial and give it a go yourself.
Why do people trade options as tied/volatility trades?
Options can be traded for many different reasons but one of the primary reasons is to gain exposure to volatility in the underlying instrument. For professional option traders, such as option market makers or volatilty trading hedge funds, this is by far the most important aspect of options trading. Whereas directional traders like to use options to create payoff profiles that reflect their view of the likely price of the underlying product, volatility traders prefer largely to eliminate the effect of changing spot price. Hence they are more interested (generally speaking) in delta-neutral trading. So when they price and trade options, it often makes sense for the delta-hedge to be part of the package. This is particular the case in the professional market where both counterparties (buyer and seller) are often using the options as volatility plays rather than as directional tools.
Where can I learn more about or practise trading tied option trades?
Where else but by logging on to Volcube?! You can include vol trades in your Volcube simulation games and practise pricing and trading them exactly as professional volatility traders do. In the Custom Play screen, choose Broker Orders : WITH DELTA. This will include vol trades in your games. The broker will request prices from you exactly as in the example above; options versus a reference price. Make some trades in the simulation and you will see your risk update; your trade log in the game will show your options trades with their associated delta-hedges. Notice how these trades affect your portfolio vega, gamma, theta etc. a lot more than your at-the-money delta. That’s the whole point of vol trades! If you have any questions about vol trades or Volcube in general, email [email protected] or fill in the form on the right.
Volcube is an options education technology company, used by option traders around the world to practise and learn option trading techniques.