You must have intuitively noticed that whenever the volatility in the market goes up, the value of the option also goes up. Now that surely sounds contrary right? After all, we always believed that value is inversely related to risk. Then how does the value of the option go up when the volatility increases. Before understanding the importance of volatility in options, it is essential to understand the concept of volatility first. Subsequently, we shall also delve deeper into the role of volatility in options calculation as well as the volatility options strategies that can be profitably employed.

But first, what do we understand by volatility? Volatility is the probability that the price of the stock will vary substantially from the average price (mean price). Volatility is typically measured by a statistical measure called the standard deviation which measures to what extent the price of a stock varies from the mean or the average price. Therefore, volatility is also a measure of risk. In the Indian market, volatility risk is depicted using the popular Volatility Index (VIX), which is calculated by the NSE on a real time basis. Having understood the concept of volatility, let us see how the volatility impacts the option values.

Importance of volatility in options valuation
To understand the role of volatility, let us take the live option chain of Reliance Industries for the February 2018 options contracts. We shall consider calls and puts in this chain.

But why do calls and puts benefit from higher volatility?

RIL 940 Call Option (Feb 2018 expiry)RIL 900 Put Option (Feb 2018 expiry)ParticularsIntrin / TimeTotal ValueParticularsIntrin / TimeTotal  ValueVol (+5%) - 96626 / 1036Vol (+5%) - 96600 / 0101Vol (-5%) - 87400 / 0101Vol (-5%) - 87426 / 1036Vol (+10%) - 101272 / 2092Vol (+10%) - 101200 / 0000Vol (-10%) - 82800 / 0000Vol (-10%) - 82872 / 2092

The above table depicts that as the volatility increases, the time value of the options is also increasing with the volatility. For a call option, volatility means the stock price could go up sharply or go down sharply. When the stock goes down, the call options will not be exercised and the loss will be limited to the premium. On the upside the benefit of volatility is entirely the option buyer’s.

In case of put option, the buyer will let the option expire in case of upside volatility and profit in times of downside volatility. Volatility makes calls and puts more valuable even when prices do not really move. That is why volatility is so important.

Using volatile strategies via options
Most traders are quite clear what to do with options when the market is expected to go up or go down. But what do you do when you are not sure of the direction of the market but are quite clear that volatility will increase. That is when you can play on the time value and that is where strategies like long straddles and strangles can be useful. The beauty of volatility is that it benefits the buyers of calls and puts and both can benefit from higher volatility irrespective of actual price movement.