There are multiple ways to deal with option pricing when major volatility expansion is triggered. The best way to deal with such scenarios is by plotting how options respond to changes in the underlying volatility and shifts in the time to expiry. Although there are 4 factors that impact options premiums, we shall talk about the impact of volatility expansion alongside a fixed rate of time decay.
We all know that OTM options lose major chunk of their value as time to expiry draws near. This is because; the premium of an OTM option is comprised of time value only. Therefore, shorter the time, faster the rate of decay. Let us consider two options, one expires in a week, and the other expires in a month. Now let us consider, the market is hit with excess volatility. The excess volatility should cause both the option premiums to expand. However, you will notice that the option with a shorter expiry will expand more than the one with the longer time till expiry. The important question is why.
In order to solve this, we need to first understand the concept behind this phenomenon. Volatility in simple words is the result of one standard deviation in the return of an instrument, in the shorter term. Therefore it helps traders understand the magnitude of uncertainty of the future price movements. With expansion in volatility, the mathematical possibility of the instrument scaling up or plunging down increases. This is where a significantly surprising event takes place. The owner of the option with shorter expiry has a lower downside compared to the owner of the longer expiry. Therefore, the price of the option with the shorter expiry tends to be more attractive than its longer counterpart.
Take a look at the 10800 strike Put today. You’ll notice that the weekly contract registered a low of Rs.2.70 and the monthly contract registered a low of 105 around 11am today. The weekly strike scaled up to Rs.22, and generated a return of 633% while the monthly contract climbed to Rs.158 and managed 50% only when Nifty plunged 117 points. The weekly contract was always the better bet provided the trader understands the impact of time value decay on both the contracts.