A review of IV (Implied Volatility) and its usefulness

asiaprop · Aug 4, 2009

thanks for sharing this but not sure it had an edge over a simple short treasury futs position. Point is people often claim they trade the option at limited risk vs other assets. I dont understand why, I can play the delta in the same risk limited way than the option.

Trading skew and IV directly are entirely different and I agree there are strategies with edge, I trade some of them myself regularly.

Quote from dmo:

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.

Martinghoul · Aug 4, 2009

Quote from asiaprop:

... 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.

I am imprecise precisely because it's not salient to the point I am trying to make.

My point about bid/offer is simple. Whatever edge you think you have is eroded by the bid/offer you have to pay. As a result, given the same expected return, the higher your transaction costs, the smaller your ex-ante Sharpe going to be.

As to your question about options vs pure delta, I can give you many examples, but they're all in my world, i.e. the world of rates, where direction and vol are often not independent. If you're curious, look up 'bull steepeners'/'bear flatteners' types of trades and you will hopefully see what I mean.

Finally, one of the other reasons to use options is the limited max drawdown aspect of it (if you're long). That's something you CANNOT replicate using the underlying outright.

asiaprop · Aug 4, 2009

disgree with every single point of yours and touched on all issues you mentioned before. BTW, I worked at a rates exotic desk before your points on the dependence of vol and rates are not plausible in the slightest.

Quote from Martinghoul:

I am imprecise precisely because it's not salient to the point I am trying to make.

My point about bid/offer is simple. Whatever edge you think you have is eroded by the bid/offer you have to pay. As a result, given the same expected return, the higher your transaction costs, the smaller your ex-ante Sharpe going to be.

As to your question about options vs pure delta, I can give you many examples, but they're all in my world, i.e. the world of rates, where direction and vol are often not independent. If you're curious, look up 'bull steepeners'/'bear flatteners' types of trades and you will hopefully see what I mean.

Finally, one of the other reasons to use options is the limited max drawdown aspect of it (if you're long). That's something you CANNOT replicate using the underlying outright.

Martinghoul · Aug 4, 2009

Quote from asiaprop:

disgree with every single point of yours and touched on all issues you mentioned before. BTW, I worked at a rates exotic desk before your points on the dependence of vol and rates are not plausible in the slightest.

I do not see any comments of yours that even remotely address what I have said.

As to your other comment, I am rather sorry for the rates desk that employed you (if indeed they did). Would you mind telling me what sort of models were used by your exotic rates desk to price trades? What sorts of trades were they?

For the record, if you're, in fact, saying that in the world of interest rate options, rates and vol are independent, you are, quite clearly, CLUELESS!

IV_Trader · Aug 4, 2009

I have a feeling that I already read asiaprop posts beforeâ¦the style is very familiar â¦must be under another handle; I just canât remember which one

Thoughts?

OddTrader · Aug 4, 2009

http://www.elitetrader.com/vb/showthread.php?s=&postid=2528592#post2528592

Quote from dmo:

IV IS just demand. It is nothing else.

In the absence of demand, an option will in fact not have any IV. That may not be obvious, because the exchanges will always display an offer of at least 1 tick, so the IV will be calculated off the mid-price between the bid and the offer.

Today for example the GS 70 puts with just 17 days remaining closed at 0 bid, .04 offer. The "mark" is thus .02. So the TOS platform (and every other platform I presume) dutifully calculates IV using an option price of .02, and comes up with an IV of 138%.

Since that "mark" price is fictitious, so is the IV that it generates. Garbage in, garbage out. An option such as that one, with no demand, has a true price of zero. And an option with a price of zero has no IV.

People seem to be foggy on what IV really is. It's so simple. IV is to options what price is to stock. When demand for a stock goes up, so does the price. When demand for an option goes up, so does the IV. If this is not crystal clear please watch the video at http://masteroptions.com/?p=3

That's really great!

I think you're going to re-write (aka re-invent) the foundation theory of options pricing! Thanks!

Quote from OddTrader:

Are you saying you are simply not capable to write down any of your thoughts or feedback regarding this thread at all? Or you are just afraid to do so (besides promoting your stuffff)!

asiaprop · Aug 4, 2009

lol, I never mentioned rates and vol are independent. We used a modified version of the SABR model.

Quote from Martinghoul:

I do not see any comments of yours that even remotely address what I have said.

As to your other comment, I am rather sorry for the rates desk that employed you (if indeed they did). Would you mind telling me what sort of models were used by your exotic rates desk to price trades? What sorts of trades were they?

For the record, if you're, in fact, saying that in the world of interest rate options, rates and vol are independent, you are, quite clearly, CLUELESS!

Martinghoul · Aug 5, 2009

Quote from asiaprop:

lol, I never mentioned rates and vol are independent. We used a modified version of the SABR model.

Perfect, SABR is, in fact, almost universally the mkt convention... However, I am now at a loss as to how to interpret your commentary. Help me, pls, asiaprop.

Here's what I said:

Quote from Martinghoul:

As to your question about options vs pure delta, I can give you many examples, but they're all in my world, i.e. the world of rates, where direction and vol are often not independent.

Here's what you said:

Quote from asiaprop:
BTW, I worked at a rates exotic desk before your points on the dependence of vol and rates are not plausible in the slightest.

How am I to understand your commentary? You seem to contradict yourself...

At any rate, what I said about options stands. I do not see any reason to disdain the trading of vol any which way you like. Pure and straight, if you're so inclined and have the ability to do it; as part of a directional trade, if you feel like it.

asiaprop · Aug 5, 2009

buddy, possible you had a drink too much?

a) let me make it very easy for you: "...the world of rates, where direction and vol are often not independent" (you said) <> "your points on the dependence of vol and rates are not plausible in the slightest" (I said)

just because you did not get the point does not mean I contradicted myself.

b) "At any rate, what I said about options stands. I do not see any reason to disdain the trading of vol any which way you like. Pure and straight, if you're so inclined and have the ability to do it; as part of a directional trade, if you feel like it."

What are you actually trying to say?

Quote from Martinghoul:

Perfect, SABR is, in fact, almost universally the mkt convention... However, I am now at a loss as to how to interpret your commentary. Help me, pls, asiaprop.

Here's what I said:

Here's what you said:

How am I to understand your commentary? You seem to contradict yourself...

At any rate, what I said about options stands. I do not see any reason to disdain the trading of vol any which way you like. Pure and straight, if you're so inclined and have the ability to do it; as part of a directional trade, if you feel like it.

Martinghoul · Aug 5, 2009

Quote from asiaprop:

buddy, possible you had a drink too much?

just because you did not get the point does not mean I contradicted myself.

What are you actually trying to say?

Anything is possible, including a version of English language where "not plausible"("not independent") = "not independent"...

Just indulge me, pls, my friend. What exactly is your point? Without reference to any previous posts, yours or mine, what are you saying? Specifically, in the world of interest rates (let's take vanilla swaptions, nothing exotic) are vol and direction independent or not?

As to what I am trying to say, I have said it arnd five times now, elaborating in various ways. I will now be very clear:
1) There IS NOTHING WRONG with using trades that have a volatility component to express a view on either vol or direction or both. There are various circumstances where different types of trades will offer specific advantages.
2) Your point about being able to replicate any directional trade done through options using straight underlying is NAIVE.

Is that clear enough for you?