What does it mean to be 'long' volatility?

When you boil it all down, options “bets” take two forms. In one form you are “betting” on the direction of the underlying product, be it a stock, bond, index, ETF, or whatever. In the other form, you are betting on the volatility of the underlying instrument. I’ll deal with both over the course of time, but for today’s purposes I’m going to look at the latter--volatility trading. What makes me want to go “long” volatility in a specific name?

First, what does it mean to be “long” volatility? Basically, it’s when you are a net owner of options in a given name. If the name goes higher, your share equivalent position (delta) gets longer, and if the name goes lower, it’s the reverse, you get shorter. Sounds great, huh? The higher it goes, the longer you get; it’s a momo dream. But alas, there are costs.

Namely, it costs money in the form of daily options decay. As each minute and each hour and each day go by, your options are worth less and less, and ergo you constantly fight the clock. In addition, you are at risk that the implied volatility of the options will decline, essentially a mass prediction in the marketplace that the underlying stock will not fluctuate to as great an extent as previously thought.

So net-buying options has clear risk (time decay and volatility declines) and reward (nice price action). So when do I like to net-buy?

There’s no one set formula, but as a general rule, I avoid bottom fishing in volatility. I want to buy options into an uptrending or steady volatility chart. Take this volatility picture of Valero (VLO | Quote | Chart | News | PowerRating), courtesy of ivolatility,.com:



The yellow line represents the implied volatility of the options, the blue line represents the volatility of the stock itself. As VLO rallied over the past year, option volatility fluctuated within a range of 30 to 45, consistent with the volatility of the stock itself. This tells me it’s a decent name in general in which to net-own options and try to earn money by fading the stock itself, and with a current volatility reading of 35, it ok timing to do so as well.

Now contrast that with one of yesterday’s option darlings, Intel.



Implied option volatility has held steady here too, at least for the last 9 month’s, but its generally downtrending and consistently overpriced relative to the volatility of the stock itself. In other words, when Intel volatility first hit 25 at the start of 2005, it was a historically low level for Intel options. But as you can see, the stock just hasn’t fluctuated widely enough to ever make options ownership a winning play. Of course past performance does not predict future results, but by the same token, why bother here to begin with and anticipate some hypothetical activity in the stock somewhere down the road? Its dead money until proven otherwise.

Adam Warner

Adam Warner is a proprietary trader for Addormar Co., Inc., specializing in option and derivative strategies. Prior to Addormar, he was an Equity Options Market Maker on the floor of the American Stock Exchange from 1988-2001.