(The following applies to traders interested in options trading, stock trading, investing, options strategies, and volatility)

QUESTION >

If I buy an option that is out-of-the-money and its volatility goes up (which raises the value of the option, but the stock never goes up to the in-the-money category), then can I still take a profit from that position?

Thanks,

KC

ANSWER >

Hi KC,

Yes, and this is one of the most fascinating aspects of options. That is, as an option trader, you do not necessarily need the underlying stock to move in order to make money.

How is this possible? It has to do with the fact that an options value increases as the volatility of the underlying stock rises (true for both calls and puts). If you buy an out-of-the-money call and volatility rises, the value of the call will rise. Bear in mind that in the real world of trading, we must have volatility rise sufficiently in order to beat the bid-ask spread and commissions. But if it does, you could certainly sell the call to close at a profit even though the underlying stock never moved.

As a side note, if you were buying the call with the sole intention of profiting from a rise in volatility, youd be better off with the at-the-money strike since it is more sensitive to changes in volatility.

However, in doing so, youre now exposed to more rise to the downside if the stock price should fall. But we can counter that movement and hedge that risk by also buying a put option. If we buy an at-the-money put along with that call (straddle) we can profit from changes in volatility without being too worried about directional movement. The call and put act to hedge stock price movement over small moves. If the stock rises a point, the call will gain about the same amount as the put loses and vice versa.

However, if volatility rises, then the call and put values rise and you can close the straddle at a profit even though the stock never made a significant move.

In fact, when professional traders buy straddles they are most often attempting to profit from a rise in volatility (rather than large directional moves that most retail investors look for). There are many strategies other than the straddle where we can profit from volatility.

But regardless of the method we choose, the point is that we can profit on an option without any movement in the stock. For long options, we can profit from increases in volatility. For short options, we can profit from decreasing volatility and time decay. Of course, these properties can work against us too. We can lose on an option without any stock price movement simply from volatility falling or from time decay.

Volatility is therefore not necessarily a good or bad thing but, instead, an added dimension where traders can profit if they are correct in their outlook. It gives us the ability to trade other aspects of the market in addition to direction. No other asset can make such claims and is what separates options from all others.

Hope this helps.