Selling volatility with derivatives

Your Essential Primer to 4 Ways to Short Volatility

By:Dr. Jim Schultz

Spoiler alert: It's not all about the VIX

  • Market prices and market volatility reliably share an inverse relationship, as one goes up, the other goes down.
  • Given market volatility’s tendency to contract over time, many traders want to take advantage of this by selling volatility.
  • But rather than sell straight volatility through VIX calls or /VX futures, a more strategic way to play volatility contraction is with short equity options.

In the financial markets, at least with equities, there is a reliable relationship between market prices and market volatility–they move inversely to one another.

If market prices move higher, then market volatility usually moves lower. If market prices move lower, then market volatility usually moves higher. One of the core characteristics of the stock market is that it tends to rise over time. Given the global economy and its emphasis on growth, this makes sense.

This gradual grind higher makes selling volatility an attractive alternative for traders, as volatility tends to slowly contract over time, mirroring the market’s upward trajectory. However, how a trader chooses to play a short volatility position is an important choice.

Selling straight volatility

Two of the more common, simpler ways to play volatility are through CBOE Volatility Index (VIX) options or CBOE VIX Index /(VX) futures. Traders can easily buy or sell VIX calls or puts, or buy or sell /VX futures, to play a long or short volatility position. Specifically, to play a short-volatility position, traders would do one of the following:

  • Buy VIX puts

  • Sell VIX calls

  • Sell /VX futures

While simple and straightforward, none of these options are super attractive for a volatility seller. VIX options are generally quite expensive, so buying VIX puts isn’t a compelling choice. So, what about selling VIX calls or /VX futures?

While market volatility does generally go down over time, it certainly goes up, too. And sometimes, it can explode to the upside, increasing by 20%, 50%, 100%, or even more on a given day. Therefore, while having naked short exposure to a straight volatility product will work most of the time, the times that it doesn’t work could prove to be catastrophic.

Selling volatility through options

Another way to play short volatility is through equity options, specifically on the short side of the option contract.

While volatility shares an inverse relationship with market prices, it shares a direct relationship with option prices. If volatility increases, then an option’s price increases, and if volatility decreases, then an option’s price decreases, all other things being equal. Therefore, if you take the short side of the option contract, you benefit from falling volatility, as that drop will lead to lower option prices—what you ultimately want as the option seller. As a result, by selling options you are indirectly positioning yourself to play volatility contraction over time. 

But furthermore, because you are using equity options to play short volatility, you’re not purely exposed to volatility only. Not only could the underlying stock price, and its movement, positively impact your position, but the simple passage of time will also positively impact your position.

These two factors give you exposure to market elements not necessarily related to volatility, and thus diversify away your volatility exposure, while still allowing you to profit from volatility contraction.

Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3

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