Introduction to Volatility Spreads

The true investor welcomes volatility … a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses.
-Warren Buffet

Volatility doesn’t only create irrational pricing in stock prices only. It also creates irrational pricing in every other instrument which includes options as well. Our aim is to capture this mispricing.

Our main task is to understand the effect of option pricing in cases of volatility contraction and volatility expansion. Fear tends to manifest itself much more quickly than greed, so the downside markets tend to be highly volatile. Whereas, in upside markets, volatility tends to gradually decline.

Delta Neutrality

Anyways, Let’s start with the most important concept of delta neutrality which is the first necessary step to dynamically hedge options.

Let’s say we have a sell position on BankNIFTY 9th Apr 19500CE at 141. Let’s have a look at the greeks for better understanding –

Delta Neutrality

Now as we can see the Delta is -5.45. It means we shall lose ₹5.45 for every ₹ 1 BANKNIFTY goes up by. Our primary job is to make it near 0.

We can do it by two ways [1]– Either We need to sell Put Options or We need to buy Call Options. Let’s buy 9th Apr 20000CE at 60.

Delta Neutrality

The delta reduced. If we buy two lots it will be near 0. But the more we buy call options the more theta decreases and we make less money with the time value. Here is another approach –

Volatility Spreads

We have sold 9th Apr 17000PE and 17500PE. As we can see, there are many ways to hedge our initial call trade setup. But, whatever is the results, it will be affected by the greeks –

  • Delta – As we have already discussed, each spread should be approximately near 0 i.e. Delta Neutral.
  • Vega – The less vega, the less sensitivity towards change of IV.
  • Gamma – It tells about how delta will change when the underlying asset moves. So, the less gamma, the better!
  • Theta – The more theta, the more time decay, the more money!
  • Obviously, the movement of the spot itself!

So, Volatility spread means –

A delta-neutral option spread which is usually established in order to take a view on changes of market volatility rather than the market direction.

We shall be looking into most common types of volatility spreads.

India VIX[2]

In India, We gauge the “volatility” (or, “fear” or, “risk”) in the stock market by the India VIX index.

It is based on the NIFTY Index Option prices. From the best bid-ask prices of NIFTY Options contracts, a volatility figure (%) is calculated which indicates the expected market volatility over the next 30 calendar days.

[1]We are not talking about Calendar Spreads, Diagonal Spreads etc. Let’s talk about options with the same expiry as of now.
[2] (“VIX” is a trademark of Chicago Board Options Exchange, Incorporated (“CBOE”) and S&P’s has granted a license to NSE, with permission from CBOE, to use such mark in the name of the India VIX and for purposes relating to the India VIX.)

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