Implied Volatility

A quick introduction for those who have not read my post before.

I trade an option portfolio, I am a stay@home dad for 2 young kids, live in New York and born in The Netherlands. I have been a member of EV for approx 5 yrs. Although I don't trade many individual stock and hardly ever will trade an underlying based on a directional assumption, I always found the interaction on EV pleasant and educational, so I stuck around to read some gems fellow contributors.

In the archives you will find a series I did approx 3 yrs ago on RUT butterflies. Those articles will give you some indication of my main recurring trade style. I add to my RUT portfolio more opportunistically based trades in many other liquid underlyings.

This morning Pascal asked if I had time available to post some more insights on option trading and since my oldest daughter is off to her first full-time school (PRE-K) I answered positive.

So this is for now the plan. Weekly I will post an article which will handle one particular aspect of options contracts. During the week I will try to post a trade and keep you posted on how that trade is working out for me.

A word of caution - options are lethal - especially if you have limit knowledge of their internal workings. My trade size, especially in the opportunistically trades is small (very small). I often trade 1, 2, or 3 lot sizes. Yes in good years my family and I will pay our bills from trading. But you don't make it in the option trading world by going large, you make it by playing very often (more on this in an other article). Sometimes I am ask to assist a fellow trader with some issues, it is ALWAYS size that got them in trouble. So please if you start following one of my trades. Remember I post one trade out of a portfolio of maybe 40 or 50 in a month. I could not careless how the trade I post works out, winner or total loss. I still run to the local cheese shop to give myself a treat.

So after long winded introduction, lets move on to the topic of tonight. An introduction of Implied Volatility (IV).

An option is a contract!. A contract to buy or sell 100 units of underlying for the set price (strike) at the agreed time (expiration date or Opex). So how do we determine the price or value of such a contract. Their are many formula's but the most famous one is called Black-Scholes.

You can find the exact formula on wikipedia (if you want). But the formula has 6 input and one output (price).
The input are last price of underlying, strike, current risk free interest rate, dividends, days till Opex and implied volatility.

What you need to understand is that all input with the exception of IV are fix. If we want to know the price of IWM Contract for OCT. The last price of the underlying is whatever it is, the strike is whatever we contract we want to calculate. The days till OCT Opex are also set. So the one parameter in the black Scholes formula which is set by the trader is IV!.
With IV the option trader shows his opinion. Do we think IWM will have a greater volatility than currently implied then we need to buy the option, if we think IWM will be more docile then we need to sell the option.

So whenever you are looking at options contract, you always need to look at the IV. Is IV high or is it low. High/low compared to itself over the last for instance 100 days. Compared to IV in other IWM Contracts with different Opex months (horizontal skew). Compared to IV in the same Opex but at the other strikes (vertical skew).

Another nite I will more talk about skew and two statements; 1. IV is always mean reverting, 2. At expiration IV is always 0.

For now I will leave you with practical use of IV for a stock trader.

IV can give you an indication what the option market is expecting in price movement till Opex. For instance take TSLA with the current IV of approx 60. The market expects TSLA to make a $20 move up or down till OCT. Keeping an eye on IV will show you if the market is adjusting towards more expected volatility or is expecting the moves to slow down a bit. With 1000's of contracts traded on every strike of TSLA. It means that some very serious money is involved in setting TSLA option contract prices and thus its IV. They can of course be wrong, and they will be wrong. But you will always see changes of opinion in IV trends to reflex the opinion all market participants.

The formula for expected move is price*IV divided by SQR(365/DTE). Where DTE is days till expiration.

Stay (theta) positive,

Ernst

Thank you Ernst.

I will be reading your posts with great pleasure, because I know that I'll learn a lot.


Pascal

I think that we will all learn much about options trading.
I will make a special section on the web site to learn the basics about options.

Options trading has some advantages over stock trading, such as limiting the loss to the premium paid (when buying call/puts) or being able to purchase stocks on the cheap by selling puts and collecting the premium.

I understand Ernst that you are a non-directional trader on options.

Look below at the weekly stock selection section.
I believe that buying call on some of these stocks could have been great, instead of buying the stock itself.

Another aspect of options trading for example in my country (Belgium,) it is that we do not have tax on each option transaction, while we have high taxes on equities. Hence, for me if I want trade from a Belgian account, I would only trade options. This is the main reason why I trade equities from London.




Pascal

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