Most option traders focus on four primary questions.
1. What is the market trend?
2. Where should I enter the option trade?
3. What is my target?
4. What is the correct stop?
At the onset we must understand why professional option traders are highly successful. You’ll notice that almost 90% of professional option trading systems are designed under statistical models of option valuation. This model revolves around the change in option premiums, with respect to the change in volatility. One of the biggest advantages of this method lies in having prior knowledge of whether an option premium is over-priced or under. In today’s article we shall discuss this component and how it is customized by professional traders to fit their trading systems.
Implied Volatility Of Options
Estimating the Implied Volatility creates the biggest hurdle for option traders. Take for example; a portfolio manager is trying to establish the VAR of his custom index in the near term. In this case, he will most likely correlate it with the volatility of the benchmark at that time. This is because he is trying to determine the risk of the portfolio, in the shorter time frame. As opposed to this, when option traders are trying to establish the value of an option, the statistical measure of volatility over the life of the option is generally considered. The question we need to ask is why?
Option Valuation
So how do professional traders work around a daunting task like determining whether an option premium is fairly valued or not. Since every option contract is unique and is a non-linear variable, professional traders do not consider a linear historical volatility model to determine the fair value of a strike, belonging to a particular contract. The solution here is to work on a volatility correlation matrix that captures the drift within the same timeframe. In other words, the implied volatility of an options contract with 3 months to expiry must be matched with 3 month historical volatility. This also means that when we are trading a contract that has 30 days to expiry, it must be correlated with a 30 day historical volatility to determine the appropriate premium of the strike. One of the most important factors that option traders must keep in mind is, shorter the time frame, wider the spread between the historical and the implied volatilities. We have observed that most institutions use the periodic volatility comparison rather than the generic 1% drift in the implied volatility method. When determining the valuation of the option, they co-relate the change in volatility with respect to the maturity of the option contract and not the generic historical volatility of the instrument.