Agricultural Commodity Marketing and Risk Management Trading Options on Market Volatility

Sensitivity Measures for Option Premiums Delta – A measure of the change in the value of the option premium for a one unit change in the price of the underlying futures contract. Usually quoted in %. If Deep-In-The-Money or if there is no time value with In-The-Money options, then delta=100, meaning a one cent change in the price of the underlying futures price will result in a one cent change in the option premium. In-The-Money Options have higher delta values than Out-The-Money Options. Further Out-The-Money the option is the lower is the Delta value.

Sensitivity Measures for Option Premiums Gamma – A measure of how fast the Delta changes as the price of the underlying futures contract changes. Delta depends on the value of the underlying futures contract relative to the strike price in the option. Gamma is a measure of how fast the Delta changes as the futures price changes around the strike price.

Sensitivity Measures for Option Premiums Vega – A measure of the sensitivity of the Option Premium to changes in the volatility in the price of the underlying futures contract, i.e., the unit change in the value of the Option Premium given a 1 percent change in the futures contract volatility. Statistically – Historic volatility is the annualized standard deviation of the first difference in the logarithmic values of the nearby futures, expressed as a percentage. Implied volatility is revealed in the option premium and can be calculated using Black’s formula.

Trading Options on Market Volatility Delta ranges in value from 1 to 100. At-The-Money Options generally have value approximately equal to 50, implying a one cent change in the price of the underlying contract will result in a half cent change in the option premium. Deep In-The-Money Options have delta value approximately equal to 100 Deep Out-The-Money Options have delta values nearer 0

Trading Options on Market Volatility The sign of the Delta dictated by the position Long At-The-Money Calls and Short At-The-Money Puts have a Delta Value of +50 Long At-The-Money Puts and Short At-The-Money Calls have a Delta Value of –50. A Long futures contract is always a +100 Delta, i.e., a one cent increase in the futures price results in a one cent gain in value to the holder. A Short futures contract has a –100 Delta, i.e., a one cent gain in the futures price results in a one cent loss in value to the holder.

Trading Options on Market Volatility Trading a Delta Neutral Position eliminates price risk and allows you to trade on Market Volatility. Buy options and offset price risk with futures contracts when you expect market volatility to increase. Example, buy 2 At-The-Money Calls with a summed Delta value of +100 and offset price risk by shorting the futures with a delta value of –100. You are Delta neutral with changes in position value driven mostly by changes in Market Volatility. If Market Volatility increases, the time value of the option premium increases. If the futures price increases 1 cent without any change in market volatility, you lose 1 cent on the futures position with a combined one cent gain on the two options positions. As an exercise- demonstrate a strategy with puts when market volatility is expected to increase.

Trading Options on Market Volatility Trading a Delta Neutral Position eliminates price risk and allows you to trade on Market Volatility. Sell options and offset price risk with futures contracts when you expect market volatility to decrease. Example, sell 2 At-The-Money Puts with a summed Delta value of +100 and offset price risk by shorting the futures with a delta value of –100. If Market Volatility decreases, the time value of the option premium decreases. If the futures price increases 1 cent without any change in market volatility, you lose 1 cent on the futures position with a combined one cent gain on the two options positions. As an exercise- demonstrate a strategy with calls when market volatility is expected to decrease.

Trading Options on Market Volatility Trading on Market Volatility requires attention being paid to Volatility, Vega and Delta Values. As price levels change, so will the Delta Values of the Options and your position may need to be adjusted if you intend to remain Delta Neutral.