Volatility is a measure of the uncertainty of the future price of a security. Options are contracts that allow market participants to expose their portfolios to the future volatility of an underlying security. The buyer of an option is said to be long volatility because she expects to profit if volatility rises. The converse is true for the seller of an option. She is short volatility.
Although options are often also simultaneously used for other purposes, such as to gain exposure to the direction in which the underlying security will move, to the future path of interest rates, or to gain leverage, among other uses, their raison d'etre is that they allow market participants to trade volatility. Indeed, forwards (or futures) already allow market participants to expose their portfolios to direction, to interest rates, and to gain leverage. We explore the other joint uses of options over the course of this book. However, the aim in this chapter is to provide a broad understanding of the concept of volatility and to communicate the central idea that an option is a bet on future volatility.
The exposition in this chapter is deliberately imprecise in order to disseminate the intuition underlying options theory and practical options trading more quickly. We will study these topics in depth and with greater accuracy in later chapters.
1.1 WHAT IS AN OPTION?
Perhaps the quickest and most intuitive way to understand the basics of options is through inspecting ...