A review of IV (Implied Volatility) and its usefulness

again, IV has zero relevance in directional trading. If you want to trade direction then you are (almost) always better off trading the underlying, only. Why? Let me ask you a question: Do you seriously believe that if you are unable to consistantly outperform the market simply by trading long or short in the underlyer you are capable of cashing in by having to be right on the timing and velocity of the move besides direction? Thats ridiculous!!! Most guys cannot even handle simple directionals.

If you want to trade gamma, you are much better off trading those instruments I mentioned earlier because you believe in future realized vol divergence from current IV levels.

I can show you that even the view of options as insurance producs is misconceived by most market participants. It almost always pays to offset a delta exposure with another pure delta rather than through an option. There are exceptions for large funds when moving cash would move the market by too much or in order to "initially fly under the radar". Even that I could contend because one of the counterparties in the end needs to hedge in cash which would move the market.

I am not saying options never make sense to trade direction but I claim that 90% (especially retail) have a completely wrong understanding of the exposure they take in options.

Most of the hyped option strategies are nothing else but a leveraged way to take exposure to the underlying. If you cannot afford to take the exposure in cash what makes you think you are better off in an overleveraged intrument....

The clear reason why brokers hype such producs is because they know that Joe does not have much money left in the pockets after so many losing punts...


Quote from OddTrader:

1. IV can be used not only for Volatility trading with options, but also for Directional trading using options.

I think IV is much more important in Volatility trading particularly when doing short-term trades. However less important in Directional trading particularly when doing long-term trades.

2. I don't understand how you can find and trade "at the lowest possible (options?) price".

Are you saying you can project the upcoming timing when the best (possible) price will appear eventually? And you don't make any trade if the best price does not come up within a period of time, then how long you would wait usually before giving up?



As every market maker can make price using individual proprietary model based on preferred/ chosen serial correlation properties, I would think the importance of IV in option trading would be easily diminishing!
More...
 
Quote from asiaprop:

pure, implied, vol was the topic of this thread.

Secondly your comment on the limited profitability on trading pure vol can be easily refuted. It does not matter whether I trade an instrument that on average fluctuates by 1% per day or a levered fx position that causes variations in the account of 5%, 10%, xx% per day. It all comes down to edge and how much you lever up is all up to you. The edge, as I described, can be extracted by utilizing the serial correlation properties to some extent.

Its all cool how you trade options, but its still you who slightly missed the point of this thread not me...
More...

Disagree...

Pure vol was the topic, but you said that 'pure' has to be the only way to trade vol. That is not true. Vol can be an aspect of a directional trade, which is also, to me, a way to trade vol. Moreover, pure vol exposure is difficult to achieve for cases where there's no access to the specific OTC instruments like variance swaps or fwd vol (it might not exist, as in the world of rates, or they might be only available to large institutional investors).

As to your second point, you're barking up a completely wrong tree. Edge and leverage have nothing to do with anything. All I am talking about is bid/offer. Most often vol is a more 'exotic' mkt than vanilla underlying, which means bid/offer is wider, which, in turn, means that your 'bang for the buck' will be less. That is my point.

Finally, I never said you're missing the point. I just think that knocking people that trade vol as an aspect of a larger view, as you have done, is unwarranted. All are perfectly legitimate ways to express a view on vol autocorrelation or whatever.
Quote from asiaprop:

again, IV has zero relevance in directional trading.
More...
Completely disagree...

To me this is incorrect on several levels.
 
Quote from asiaprop:

The clear reason why brokers hype such producs is because they know that Joe does not have much money left in the pockets after so many losing punts...
More...

I wish you guys would just leave me out of this!

Joe.
 
A post about IV could be practically useful that I found on the optionnetics site written by its staff member:

Q

Hi there -

Although IV does provide a market estimate for the expected volatility (non-directional movement) of the underlying, there are a couple of things to consider in this value. At the end of my response there's a tool I just read about that may help you with what you're trying to accomplish.

First, since IV is kind of a "plug value" it will not always reflect just future movement expected. A plug value is what's left after other factors have been accounted for in the pricing model. What if an institutional trader comes into the market wanting to protect a big position for a client? Let's say they have a substantial MSFT position they want to protect ... if they create a large collar (buying MSFT puts and selling MSFT calls to off-set the cost) they have increased put demand and call supply which is reflected in option prices.

So in that case, IV as a plug value increases. You never know why supply/demand is coming into the market and what impact it has on premium and IV. It may suggest something is going on with the underlying security or not.

The second thing to consider is that historical volatility (HV) represents a big portion of IV too. It makes sense - market participants can't predict the future so it's reasonable to look at the past to gain some insight or guidance on what may happen. HV & IV charts are nice in that they provide a quick view of common volatility levels along with spikes or unusual occurrences that may be affecting current levels. Even though it's valuable to consider HV, there's no guarantee a stock will continue to behave as it has in the past.

I'm going to incorporate and reference the "gamma rent" concept I just read about in an article by Gary Norden in the Aug Active Trader magazine issue. It may help provide you with another tool to conisder with your valuation assessments (remember, no guarantees in the market with any tool).

The approach uses IV and and price of the underlying to calculate the daily range for the stock implied by the option premium. The IV% for an option is divided by the square root of 250 to obtain a Daily IV%. This value is multiplied by the underlying price to give you a value that is used for range purposes.

As an example, using an IV% value of 27.15 for XAU, the gamma rent is calc'd as follows:

IV% = 27.15,
Daily IV% = 27.15 / sqrt (250) = 1.72% -> 0.0172

XAU index level = 140.07

Gamma Rent = 140.07 x 0.017 = 2.403

So the IV calculated from the model suggests a daily range of +/- 2.403 for the index. I need to provide more detail, but this approach uses different market assumptions (think Black-Scholes) that say this represents 1 standard deviation. In another words, the option premium is saying the market thinks there is a 68% percent chance that XAU will move in a +/- 2.403 range that day.

You can then look at past ranges (High - Low) or variations on the Average True Range (ATR) to decide if the option's IV is providing a reasonable estimate about the movement of the index. You're still looking back at a volatility measure, but starting to incorporate IV as a price ranges too. Since IV isn't held constant you can't really just multiply 2.403 to the # of days to expiration to pinpoint a future value, but it is a tool that you can add to your assessment.

I just read about gamma rent, so I haven't done a lot of testing myself on it, but it makes sense from a trading standpoint and is worth a look. I thought it was also kind of on target for what you were asking.

Does that help?

Thx, Clare

UQ
 
Who ’s afraid of volatility? Not anyone who wants a true edge in his or her trading , that’s for sure

http://www.ivolatility.com/news/Putting_volatility_to_work.pdf

Q

The volatility to use is an individual’s choice. Some prefer to use short-term historical volatility while some use implied volatility. The stock price is usually the previous close, but it is not uncommon to use the open price to calculate the daily range, especially when, as has been the case lately, many stocks open at a gap from the previous close. The actual trading strategy is entirely up to the trader. But an example of one could be to enter a trade when the stock has moved beyond the 67-percent confidence range and take profit when it comes back in the range. Use the 90-per-cent range as stop-loss levels. Volatility plays a crucial role in every option, stock, futures and currency trader’s life, whether they are aware of it or not. Understanding how volatility behaves and its relation to the market will give you an advantage you cannot get from simply analyzing price.

UQ
 
Analysis of Historical and Implied Volatility of the S&P 100 and Nasdaq 100 Indices by Christina Chiu

http://w4.stern.nyu.edu/emplibrary/Christina_Chiu_honors_2002.pdf
Q
The data presented in this analysis consistently indicate that, on average, implied volatility is
higher than historic volatility for both OEX and NDX. This tendency may be attributable to the
fact that the market reacts more negatively to an increase in implied volatility than it reacts
positively when implied volatility declines. If this asymmetric reaction is assumed to be due to
risk aversion, then market declines will lead to a large increase in the demand for options, which,
in turn, lead to increases in the price of options. Since these option prices are then used in the
Black-Scholes model to imply the level of volatility in the underlying index, an option price that
is too high (perhaps due to excessive demand) will imply a volatility that is too high. As a result,
implied volatility will generally be higher than historic, or actual, volatility. Relating implied
volatility to expected volatility, the asymmetric market reaction to changes in implied volatility
will induce a tendency for investors to overestimate expected volatility, thus causing options
prices to be overvalued, and the volatility implied from these prices to be too high.

The relationship between implied and historic volatility is important, as it is often the basis of
forming trading strategies in the options market. The volatility implied in an option price is
likely to be a good predictor of future volatility if the market is efficient and the Black-Scholes
option pricing is correct. It is thought that if implied volatility does, indeed, contain information
in forecasting future realized volatility, then implied volatility may be useful in predicting stock
market returns. The results of two well-known studies [see Christensen & Prabhala (1998) and
Fleming (1998)], both using S&P 100 index option data to study the relation between implied
and historic volatility, suggest that implied volatility is, indeed, an efficient forecast of future
realized volatility that outperforms historic volatility and contains incremental information in
forecasting
UQ
 
... or whatever.

are you imprecise on purpose? I dont get your point about "bid/offer"???

The point of this thread was about IV and its usefullness. I mentioned that one advantage of trading isolated IV is due to the empirical evidence of serial correlation. Show me where you want to trade direction but by implementing an options position you gain edge over a pure delta position.
 
Quote from asiaprop:

Show me where you want to trade direction but by implementing an options position you gain edge over a pure delta position.
More...

Such setups don't come along very often but they do happen. The ones that work for me are when the normal skew in a contract is reversed and IV is historically cheap. The play is to buy ridiculously cheap, far out of the money, back-month options.

The best example I can give is May of '07, when all the world was wildly bullish on T-bonds. December '07 and March '08 OTM puts were absurdly cheap, and selling at the same IV as the ATMs. There was good reason to go short T-bonds, but buying those far OTM puts was a much better play than shorting the futures, which soon dropped from 112 to around 104.

IV played a dual role in that directional play:

1. The cheapness of the puts and flat downside skew was a huge clue that bullishness was excessive and a drop therefore imminent.

2. The cheapness of the puts provided a way to play it with limited risk and big upside potential.
 
You must log in or register to reply here.
Back
Top