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A review of IV (Implied Volatility) and its usefulness
- Thread starter OddTrader
- Start date
Quote from stereo70:
You disagree with this(?): 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.
Don't worry, S70, asiaprop will be back. His BS is predictable.
OKI, I am truly happy that we have cleared this one up...Quote from asiaprop:
i think we all agree on the fact that vol is a function also of spot relative to strike, so yes there is a relationship and I never contended that.
My point was that it does not pay (relative speaking) to establish a pure directional view through an option position unless you are absolutely right on a number of variables which, I argued earlier, the average retail guy is over time incapable of correctly predicting. The same applies to rates options as well (caps/floor/swaptions, I have traded them professionally myself)
As to your other point, I am now totally lost, as it seems to have nothing to do with our original discussion. What does 'average retail guy' have to do with anything? Moreover, how can "the same" conclusion apply to things like swaptions, which are simply not available to an "average retail guy"? Finally, your conclusions are just plain wrong. It obviously pays, relatively and absolutely speaking, to do all sorts of conditional directional trades using options. I have mentioned examples of the most common trades of this sort, but there's a whole multitude of them in the world of fixed income, whether OTC or exchange.
Overall, in summary, as of now, I just don't see how all your claims can possibly be true. Your views are naive, your familiarity with the rates mkt is cursory at best, your statements are self-contradictory and you're vague about the things that actually matter. Finally, it makes me extremely suspicious that you seem to have professionally traded vol in EVERY single asset class out there, including fx, vanilla rates, rates exotics and indices. Can you explain how that's possible? Myself and every trader I know specializes in an asset class (with the exception of very tiny group of REALLY good macro traders). So I, for instance, unless I perceive the question to be more or less generic, would never dare to express an opinion about an asset class I don't know much about, such as stocks. I prefer to shut up and listen and maybe learn something. Somehow you seem to know and to have experienced everything...
At any rate, I would be happy to be proven wrong in my view...
I am pretty sure we're talking about the same thing, but maybe dmo is the best person to speak to that. We don't NEED IV for options. We choose to use IV for options, sorta like we choose to use yields for bonds. It's convenient.Quote from OddTrader:
1. Unsure whether DMO and you are talking about exactly the same explanation. Are you sure DMO talking about "IV IS just demand" is the same thing as your "everything is about equilibrium pricing"? As if IV is no different to evrything, the why do we need to use IV for options?
Well, I don't know what to say to that. I am hurt. I don't think good understanding of IV in relation to options can be "provided". Think about this way. Let's say you're a new grad, who gets hired by a widget manufacturer to sell and market widgets. Do you expect to immediately understand why widget prices fluctuate and how? Your boss might give you some guidelines, but you need to experience the widget mkt to get a feel for things. Same with vol...Anyway I personally just don't feel either of you wouuld provide a good understanding of IV in relation to options.
It's the supply and demand of volatility, some of which is sorta like supply and demand for insurance. Sometimes it's more complicated than just plain insurance, but let's not get into that. I can give you several examples, but again they come from the world of interest rates, so I am not sure whether they will be meaningful to you.2. Specifically, what is the IV measure in relation to (what?) other measures/ factors, and can you provide detail for supply/demand of what? An example would be appreciated. Thanks!
Quote from Martinghoul:
It's the supply and demand of volatility,
You could be correct. But I think DMO originally mentioned only Demand, now he changed it to demand and supply, same as yours now.
However, I still don't follow the point how supply and demand of volatility exists, as volatility (of prices) itself is either a statistical calculation or an expectation of future value which is derived/implied by a caluculation based on any chosen model you prefer . Who would demand a stistical calculation?
imo, IV is about projected Expetations of volatility of the underlying during a future period of time. There are several major sources for volatility (implied or else), and both price and demand of an option are included.
Options prices signify Supply of options, whether there is any demand of them or not. Therefore IVs are always available individually and accordingly for each price (based on projection of future volatility of the underlying), disregarding whether any demand of an option or not.
http://en.wikipedia.org/wiki/Implied_volatility
Q
Implied volatility as a price
Another way to look at implied volatility is to think of it as a price, not as a measure of future stock moves. In this view it simply is a more convenient way to communicate option prices than currency. Prices are different in nature from statistical quantities: We can estimate volatility of future underlying returns using any of a large number of estimation methods, however the number we get is not a price. A price requires two counterparts, a buyer and a seller. Prices are determined by supply and demand. Statistical estimates depend on the time-series and the mathematical structure of the model used. It is a mistake to confuse a price, which implies a transaction, with the result of a statistical estimation which is merely what comes out of a calculation. Implied volatilities are prices: They have been derived from actual transactions. Seen in this light, it should not be surprising that implied volatilities might not conform to what a particular statistical model would predict.
UQ
McMillan (Options as a strategic investment, page 766):
"If implied volatility increases, the call price would increase, and if the increase were great enough, might impact some time value premium to the put.
Hence, an increase in implied volatility also may increase the price of a put, but if the put is too far in-the-money, a modest increase in implied volatility still won't budge the put.
That is, an increase in implied volatility would increase the value of the call, but until it increases enough to be greater than the carrying costs, an in-the-money put will remain at parity, and thus a short put would still remain at risk of assignmnet."
Of course, even McMillan could be wrong!
"If implied volatility increases, the call price would increase, and if the increase were great enough, might impact some time value premium to the put.
Hence, an increase in implied volatility also may increase the price of a put, but if the put is too far in-the-money, a modest increase in implied volatility still won't budge the put.
That is, an increase in implied volatility would increase the value of the call, but until it increases enough to be greater than the carrying costs, an in-the-money put will remain at parity, and thus a short put would still remain at risk of assignmnet."
Of course, even McMillan could be wrong!
Schap (The complete guide to spread trading, printed 2005, page 247):
"This example underscores that implied volatility is simply the expected volatility that the option price quote implies and that it is not necessarily equal to historical volatility.
The professional traders at the major trading houses estimate what they think the volatility will be between the option transaction date and option expiration. This implied volatility estimate forms the basis for their pricing of the options.
When these market professionals consider the situation to be especially risky, the implied volatility will be several points higher than the historical volatility."
"This example underscores that implied volatility is simply the expected volatility that the option price quote implies and that it is not necessarily equal to historical volatility.
The professional traders at the major trading houses estimate what they think the volatility will be between the option transaction date and option expiration. This implied volatility estimate forms the basis for their pricing of the options.
When these market professionals consider the situation to be especially risky, the implied volatility will be several points higher than the historical volatility."
Once you normalize IV data relative to strike price, volatility, and time, smile structures are remarkably stable. This smile structure can form the basis of predicting what option price should be.
This stability of smile structures probably is of more importance to market makers and people who run portfolios of options, than the retail speculators. Reference the work of Robert Tompkins.
http://www.frankfurt-school.de/cont...y/faculty_alphabetisch/Tompkins/tompkins_publ
This stability of smile structures probably is of more importance to market makers and people who run portfolios of options, than the retail speculators. Reference the work of Robert Tompkins.
http://www.frankfurt-school.de/cont...y/faculty_alphabetisch/Tompkins/tompkins_publ