When a trader gets conclusion of the volatility is being underestimated (via volatility cone or some other technology), actually there are multiple ways for his trading. (Let's assume the underlying instrument is equity). 1. Long an option and hedge the delta, to gain from the rallying of volatility. 2. Long straddle strategy to gain from the stock price movement. 3. Long gamma strategy to gain from the stock price movement.
Of course there are more strategies but I just listed these 3 to make the discussion simple and clearer. Let's assume the volatility does rally as expected. For #1, it makes money from option price rallying as the higher volatility. (Here the volatility is defined as Standard Deviation of stock log returns) For #2, it makes money from movement of stock price. (Movement should exceed the profit-loss boundary of straddle. E.g. 87.0-95.0) For #3, it makes money from movement of stock price. (Movement should cover the time decay of option)
The #2 and #3 are equivalent to #1 to some extent, as the higher volatility also means the larger price movement. But they are still not exactly same. When vol rallies 12%, #1 profits, however maybe the stock price movement can not reach the profit-loss boundary for #2 or can not cover the time decay for #3. Option trading is complex and traders have to using math model for risk measurement (and pricing). And seems the models for option are almost based on volatility.
Question 1: How to measure the risk of option strategies like #2 and #3. (I mean the pre-check of risk before trading, not calculating Var at end of a trading day). The models focus on stock volatility could not measure the stock price movement exactly I think, like mentioned above.
Another question is about the risk management after trading. Var is usually used for the portfolio risk management, but option trading has more greeks explored than other trading like cash equity. In our example the main risk of #3 is theta (time decay) risk.
Question 2: So is there any other specific method/model/formula to measure risk for option trading against greeks (like theta in #3) apart from Var? (Some institutions like Bank and Market Maker pay more attention to Var maybe because of the regulation like basel II?)
Much appreciate if you could help on these 2 questions of option market practice. Thanks in advance.