Why Volatility Matters

Why Volatility Matters

Many option traders choose to ignore volatility and trade options based solely on directional beliefs. However, this approach ignores the value of options in terms of volatility and large losses can occur - even if you are right on the direction - as the following real-life example shows.

On December 16,2004, VimpelCom (VIP) was trading for $31.41 as shown by tire quotes in Figure 1:

Most option traders who were bullish on the stock might be tempted to buy a call option to leverage their outlook. Figure 1 shows that the $31,625 calls were asking $3.50, the $33,375 calls were asking $2.50, and the $35 calls were asking $1.75.

On December 29, just thirteen days later, the stock rose significantly horn $31.41 to $34, which is a healthy 8% increase (over 200% on an annualized basis). This certainly sounds like it should leave tire trader with a nice profit on the leveraged calls but Figure 2 tells a different story. The $31,625 call was bidding only $2.90 thus leaving the trader with a 17% loss for being correct on the direction of the stock.

What would have happened if you purchased either of the other calls? If you had purchased tire $33,375 calls, you would have a 28% loss (paid $2.50 and sold for $1.80) and a massive 42% loss (paid $1.75 and sold for $1.00) had you purchased the $35 calls. No matter which call you may have chosen in Figure 1, you were left with a substantial loss in Figure 2 even though the stock’s price rose substantially. This example clearly shows that understanding stock price direction is not enough to trade options profitably.