In 1998, Pfizer (PFE) introduced Viagra, the little blue pill that has “reinvigorated” relationships the world over. And another “V” word has a similar transformational impact on option prices and can give a portfolio’s performance a jolt if an investor knows how to take advantage of it. Volatility, a misunderstood and maligned concept in the financial world, often inspires fear. But what volatility does to option prices is analogous to the magic of Pfizer’s product.

When volatility is higher, the potential profit is higher, too. That’s why traders love volatility

How so? Take a look at some Pfizer options. On both Dec. 26, 2018, and March 27, 2019, Pfizer was trading for around $42.10. On Dec. 26, the 45 call and 39 put with 51 days to expiration were trading for $0.65 and $0.80, respectively. On March 27, the 45 call and 39 put with 51 days to expiration were trading for $0.18 and $0.39, respectively. Same stock price, same day to expiration, but the 45 calls in December were trading 261% more than they were in March, and the 39 puts in December were trading 105% more than in March.

That’s an individual stock. Take a look at the SPX index options. On both Oct. 10, 2018, and March 5, 2019, the SPX was trading around $2,790. On Oct. 10, the 2900 call and 2700 put with 44 days to expiration were trading for $12 and $42.40, respectively. On March 5, 2019, the 2900 call and 2700 put with 44 days to expiration were trading for $5.45 and $21.90, respectively. Just like the Pfizer example, the SPX index price was the same, and the days to expiration were the same. But the 2900 calls in October were trading 120% more than they were in March, and the 2700 puts in October were trading 93% more than in March.

Volatility Strikes

That, ahem, inflation of the option prices happened because of volatility. Several factors determine an option’s price: the stock price, its strike price, time to expiration, interest rates, dividends and volatility. If all of those factors hold constant except for volatility, comparing option prices gives a clear and dramatic example of the impact of volatility. That’s what those options in Pfizer and SPX illustrate. A change in volatility can have a huge impact on option prices.

How much does vol have to rise to do that? For those PFE options, the 45 call had a 26.5% vol in December and a 16.6% vol in March. The 39 put had a 32.4% vol in December and a 22.5% vol in March. For the SPX options, the 2900 call had a 12.85% vol in October and a 9% vol in March. The 2700 put had a 19.8% vol in October and a 14.8% vol in March. Those aren’t huge changes in volatility, but their impact on option prices is.

OK, so higher volatility pushes up the prices of options if all other factors stay the same. But what does that do for the inves- tor? While Wall Street and just about every self-proclaimed trading expert talks about buying options, savvy traders know that selling options has a higher probability of making money. And the higher the price investors get for an option, the more potential profit they make. Think about it this way—if an investor bought that SPX 2700 put, regardless of its price, the SPX would have to have dropped more than 3.5% in 44 days to be profitable. Sure, it can happen. But just as likely the SPX could rally or stay the same or just drop, say, 2%. The long 2700 put would be profitable in none of those cases.

Compare that to selling the 2700 put. If the SPX rallies, it’s profitable. If the SPX stays at its current price, it’s profitable. If the SPX drops 1%, 2%, 3% by expiration, that short 2700 put is still profitable. As long as the SPX stays anywhere above $2,700, the short 2700 put is profitable. With short options, there are simply more ways to be profitable, and when volatility is higher, the potential profit is higher, too. That’s why traders love volatility.

Why it works

Why does volatility push up the prices of options? The reason is that volatility is the market’s estimate of how much a stock or an index might move, up or down. The bigger the moves the market expects, the higher the volatility, and the more traders are willing to pay for out-of-the-money options. They think there’s a better chance for the stock to move up or down enough to make that long option profitable. So, the price of the option gets “bid up,” and thus higher volatility means higher option prices.

But the problem with trading with the expectation of that big move is that it usually doesn’t happen. Option implied volatility (which is, as the name states, derived from the option prices themselves) tends to overstate the actual volatility the stock or index will trade at in the future. That overstated vol means that option prices are probably a little higher than they should be, and why selling them tends to make money over time. That’s why volatility is actually good for a portfolio, as long as investors use the correct strategies.

Selling that SPX 2700/2900 strangle (short the 2700 put and short the 2900 call) took in a $27.35 credit when vol was lower, but at $54.40 credit when vol was higher— almost twice as much. The credit investors get when selling a strangle is its max potential profit, and they keep that credit as profit if the SPX is between $2,700 and $2,900 by the option’s expiration. Obviously, a $54.40 credit means larger potential profit than $27.35 credit does, and is why higher volatility makes option traders drool.

Takeaway

Rather than moan when volatility is higher, look at the situation as an opportunity to boost investment returns. To do that, stay engaged with the market, looking at the major volatility indicators, such as the CBOE’s VIX, for example, and understand option strategies well enough to take advantage of high vol when it comes. High vol tends not to stick around very long, and the market can’t just pop a Viagra to boost vol. Because high vol tends to be fleeting, it won’t wait around for investors to get ready. So, study option strategies ahead of time and prepare to take action when volatility spikes.