Options (Part 2)
Up to this point, we have looked at options as a tool for expressing a directional view in the underlier. We have made some qualitative observations about the sensitivity of options to changes in volatility (σ ) and time (t), which take on a more formal structure in the derivation of the Black-Scholes formula. We have also encountered the concept of a delta hedge and how the combination of an option and an offsetting position in a delta-equivalent number of shares creates a delta neutral portfolio that is locally unaffected by changes in the underlying stock price, but does retain its sensitivity to changes in volatility and time.
In this chapter we introduce a new way of looking at options and a new type of trader—the volatility (“vol”) trader. A vol trader uses delta-neutral options positions to express directional views on the level of volatility in the underlying stock. Vol traders are not betting on the direction of the movement of the stock, but rather on the quantity of movement, whether up or down. The options market makers at Wall Street investment banks are volatility traders and on many trading floors they are not actually referred to as the options desk but rather the vol desk. While a vol trader will frequently have a directional view on the stocks he covers and bias his delta exposures accordingly, his primary focus is on volatility and his book will tend toward delta neutrality.