Options are financial derivatives that give an investor the right but not the duty to buy (or sell) an asset at a predetermined price within a certain period. This right can be traded and even sold to other investors who wish to utilise the options contract.
The worth of an option is determined by its strike price, which is usually set relative to current market prices. The further away this strike price is from current market prices, the more valuable the option becomes as it will likely become profitable for the holder irrespective of where market prices head next.
High-frequency trading strategies use options in different ways than long term buy-and holders or simply traders looking for short term gains with minimal risk. High-frequency trading uses algorithms involving technical analysis that rely on short term market movements.
These strategies often don’t require large amounts of capital to be effective, which is beneficial for smaller traders with limited funds. Understanding how options are used in these strategies enables one to make informed decisions when trading with derivatives. It can improve risk management and overall profitability when utilising high-frequency trading strategies.
One high-frequency trading strategy where options are commonly used is volatility arbitrage. Volatility arbitrage involves taking advantage of the implied volatility (IV) change between option prices on stocks with different IV levels. For example, one can sell an at-the-money put on stock A and simultaneously buy an at the money call on stock B. Both assets expire simultaneously and have similar underlying assets to ensure that they behave similarly.
When the options currently trade at parity (or equivalence), it indicates no difference in their respective IV levels. In this case, a trader would be indifferent to buying or selling both assets as neither will perform better than its counterpart after being held for the same amount of time.
Suppose the implied volatility on stock A decreases and B stays the same. In that case, there is an opportunity for profit as the at-the-money put on stock A becomes more valuable (relative to calls) due to a lower IV. It happens because puts are generally used when expecting assets to decline in value when IV is high and decreases as IV falls. Therefore, it makes sense that this strategy works better with stocks with higher IV levels and thus more significant amounts of volatility.
Volatility risk reversal
This commonly used strategy is where traders buy call options and sell puts with different expiry times – thereby creating a risk reversal position. The trader does not necessarily have to own the underlying share for this strategy to be profitable, but they must have access to stocks traded in the market.
The sale of puts hedges out most of the downside risk while allowing for more significant potential gains if the stock price is above the strike price when it expires. Meanwhile, buying call options allows traders to benefit from a rise in stock prices by purchasing shares at the strike price rather than higher market prices. Like volatility arbitrage strategies, volatility risk reversal works better with assets with higher IV levels because there is more room for capital gain when using high IV assets.
This approach involves creating two positions, one long and one short, with different expiry times. The long position involves selling an out-of-the-money put option, while the short position is created by selling an out-of-the-money call option. This strategy works best when there is high IV in the market because having higher levels of volatility allows for more significant capital gain using calls or puts depending on whether the stock price rises or falls over time.
Ratio spreads are directional trades that have limited risk and unlimited reward potential. One side of this strategy involves buying at least one contract but no more than twice as many contracts as ones being sold. Meaning that if one sells two calls with a 50% delta, they will need to buy at least three underlying assets, so their net delta is 0. This strategy works best with a high IV because this allows for more significant capital gain.
Now that you know more about these strategies, why not try them with Saxo?