Options and Trading Volatility: Expressing Views Through Derivatives
This is the second half of Chapter 4, and it is where options come alive. The first half covered basis trading and swap spreads. Now we get into the forward-swap relationship, and then spend serious time on how traders use options to express views on both direction and volatility.
The Forward-Swap Relationship
Before we jump into options, there is a quick section on the forward-swap relationship. Think of it as a swap spread trade using forwards instead of spot instruments.
Instead of buying a cash bond and receiving fixed on a swap, you sell a bond future and receive fixed on a forward-starting swap. The effective date of the swap matches the maturity of the bond future, and the swap’s final maturity matches the CTD bond’s maturity. Same logic, different instruments.
The authors give a quick example using US Treasury futures and a 5-year forward-starting swap. The forward swap spread at the time was about 85 basis points. You create a DV01-neutral trade and wait for the spread to move. It is the same conceptual framework as a spot swap spread trade, just shifted forward in time.
Options: Direction Meets Volatility
Now the real fun begins. The authors set up a two-dimensional matrix that captures both directional views and volatility views. This is how professionals think about options. Not just “will the price go up or down?” but also “will implied volatility rise or fall?”
If you buy a call, you are not just bullish on the price. You are also long volatility. The option has positive delta (direction) and positive vega (volatility). A long put is bearish on price but still long volatility. Selling options flips both exposures.
Vertical Spreads: Bull and Bear
Vertical spreads let you express a directional view with limited risk. A bull spread uses a combination of options to profit from a rising market, and a bear spread profits from a falling market.
Here is an important distinction. You can build a bull spread with calls (buy a low strike, sell a high strike) or with puts (buy a low strike, sell a high strike). Both express the same view, but the cash flow profile differs. The call version costs you premium upfront. The put version generates premium. The one that costs money has a better risk-reward ratio at expiry.
The nice thing about vertical spreads is that they are roughly gamma neutral, vega neutral, and theta neutral at inception. Your main exposure is delta. As the underlying moves far from the strikes, the deltas net to zero and the position stops changing value.
Compared to just buying or selling the underlying, spreads give you defined risk. You know your maximum loss and maximum gain. The tradeoff is capped upside.
Pure Volatility Strategies
This is where it gets really interesting. Volatility strategies aim to profit from how much the market moves, regardless of direction.
Straddles
The classic volatility trade. Buy a call and a put at the same strike (usually at-the-money forward), same maturity. You are now:
- Delta neutral (call delta offsets put delta)
- Double gamma positive (both options add gamma)
- Double vega positive (both options add vega)
- Double theta negative (both options cost you time decay)
If the market moves a lot in either direction, you profit. If it sits still, you lose money from time decay. That is the fundamental tradeoff. You are paying for the right to benefit from big moves.
A short straddle is the mirror image. Sell both options. Collect premium. Pray the market stays calm. You earn theta every day but you are exposed to unlimited losses if things get wild.
Strangles
Strangles are like straddles but with the strikes set out-of-the-money, typically at a 25 delta. Same concept: buy both a call and a put. But since the options are OTM, they cost less. The tradeoff is that the market has to move further before you start making money.
Strangles break even more slowly than straddles but they also lose less per day from time decay. If the market does not move, a short straddle earns more than a short strangle. But if the market blows up, the straddle hurts more.
An interesting point the authors make: strangles can profit as the options approach expiry because the volatility smile tends to become more pronounced over time. The OTM options may see their implied volatility increase even if the ATM volatility stays the same.
Risk Reversals
Risk reversals measure how much the market is willing to pay for downside protection versus upside exposure. They capture the skew in the volatility surface.
A bullish risk reversal: buy an OTM call, sell an OTM put, delta hedge to neutral. You are betting that call volatility will rise relative to put volatility as the market goes up.
A bearish risk reversal: buy an OTM put, sell an OTM call, delta hedge to neutral. You are betting that put volatility will rise relative to call volatility.
The position starts neutral on all the Greeks. But as the underlying moves, one option dominates. If the market rises and you hold a bullish risk reversal, you become delta positive, gamma positive, vega positive, and theta negative. If the market falls, all those signs flip (except delta stays positive). That is why it is called a risk reversal. The direction of the underlying changes the entire risk profile.
Risk reversals are quoted as a spread. Something like “0.4/0.5 calls over puts” means the dealer will pay 0.4% volatility to buy a call and sell a put, or earn 0.5% to sell a call and buy a put. This tells you which direction the market is leaning.
Hybrid Strategies
There are four hybrid strategies that mix direction with volatility: call ratio back spreads, put ratio back spreads, call ratio spreads, and put ratio spreads.
Take the call ratio back spread. You sell one ITM call and buy two OTM calls. It is basically a bear spread plus an extra long call. The position generates premium upfront (credit strategy), starts delta neutral, but is gamma and vega positive. If the market rallies hard, you profit. If it falls a lot, you also profit from the sold option’s premium. The worst outcome is if the market barely moves.
Assessing Volatility: Is It Cheap or Rich?
The authors highlight a key question every options trader needs to answer: given where implied volatility is right now, is it cheap or rich relative to what I expect?
Some things to consider:
- What is the long-term average volatility? Implied vol tends to revert to the mean.
- What is the trend in historical (realized) volatility?
- What is the spread between implied and historical volatility?
- How does implied vol relate to the underlying price level?
- How stable has volatility been?
There is a useful shorthand formula. If implied volatility is 8.68% annually, the 1-month value is about 2.51%. From that you can estimate the expected daily move. If you think the market will move more than that on average, the option is cheap. Less than that, it is rich.
Caps, Floors, Swaptions, and the Wedge
The chapter closes with the relationship between caps/floors and swaptions. This is a fixed income specific section but the idea is universal.
A cap is a strip of call options on forward rates. A swaption is an option on a swap, which is itself derived from forward rates. A cap is a basket of options. A swaption is an option on a basket. The basket of options is always worth more unless all the forward rates are perfectly correlated. The difference is called the “wedge.”
Trading the wedge means trading implied correlation. If you think forward rates will stop moving together, buy caps and sell swaptions. If you think they will stay correlated, do the opposite.
The wedge should theoretically always be positive (caps should trade at higher vol than swaptions). But the data shows it went negative for extended periods. That implies correlations above 100%, which is mathematically weird. In practice, the correlation measure here is more intuitive than formal. The relationship does not obey strict no-arbitrage rules.
My Take
This second half of Chapter 4 is dense but worth the effort. The options matrix is a genuinely useful mental model. Every time you look at an options trade, you should be able to place it on that grid: where is it on direction? Where is it on volatility?
The risk reversal section was the highlight for me. The idea that the entire risk profile of your position flips depending on market direction is not something you appreciate until you see it laid out clearly. That is why options are hard. Your position today might look nothing like your position tomorrow.
And the wedge trade is the kind of thing that separates people who “know options” from people who actually trade them. You need to understand correlation, forward rates, and the structural difference between a basket of options and an option on a basket. It is not beginner material, but the authors explain it well.