Buying Options w/High Implied Volatility, Not Good. But What If...

[Gravestone Doji]

First off, sorry about the long post. I needed to get my point across and did so as briefly as possible. I think/hope you'll find my comments interesting.

I've read many times how an Option Trader would be better off buying options when implied volatility is low, because it means they're paying a lower price which in turn reduces the break-even point, thus increasing the probability of profit.

By the same token, Option Traders would be better off writing options when IVol is high, because it means they're receiving a higher premium which in turn increases the probability of profit.

This has been the wisdom gleaned from every option trading book I've ever read, and it seems to make good sense. Because a drop in IV from a high level back to a normal level can negatively impact the price of an option, by a significant amount.

So don't buy options that have relatively high IV levels, right? Only consider selling them, Yes? Practice this over and over and make money, sound right?

Well, according to the option gurus this is the way to do it. But let me ask you this:

1.) Who's selling low IV options? Someone is.
2.) Who's buying high IV options? Someone is.
3.) Are these somebodies all unknowing amateurs?

Here's another thing to ponder. If IV is low, it's low for a reason. The market makers and option traders do not expect much movement in the underlying. If the most well informed market participants agree that the underlying is not likely to move much, is this the time to buy options? You know something they don't?

If IV is high, it's high for a reason. The market makers and option traders expect the underlying to move a lot and be quite volatile. If the most well informed market participants agree that the underlying is about to make a significant move, is this the time to sell options? You know it won't move much? Know something they don't?

Of course if you can accurately forecast future volatility, you could do very well and make a lot of money in the options market. And in essences, that's what you're doing when you buy cheap options (or sell expensive ones). You're making a forecast of how volatile the underlying will be in the future, and you're betting that you're right.

So when you buy an option w/low IV, you're betting that the underlying is going to move a lot (your prediction of future volatility), and the professionals (who have low IV priced into those options) are wrong.

Yet that's the message that option books and gurus are preaching; buy cheap options and sell expensive ones. I'm just wondering how wise it is to assume those who are on the floor everyday, making a market in options and hedging their positions, are dead wrong when IV is at extremely high or low levels. Maybe it's better to buy or sell options when IV is somewhere in the middle, near its norm? Or perhaps a punter should buy when IV is high, because according to the pro's and well informed, a move in the underlying is imminent?

Just some thoughts I've been pondering lately. I welcome your comments or opposing viewpoints.

 

[forex-forex]

Quote from Gravestone Doji:

Or perhaps a punter should buy when IV is high, because according to the pro's and well informed, a move in the underlying is imminent?

But which direction? You could buy straddles/strangles but then you would need a really big move.

 

[atticus]

The buy-side lifting an offer = paying a premium to the fairval figure to the market maker, who receive this edge as a function of adding liquidity. Buy-siders pay the spread as a penalty for taking liquidity. Market maker's are concerned with spreading vol at edge, not with taking large vol-bets.

I don't know where it's written that low-vol begets a large move. It's spurious to make that connection. Vols trend/drift.

 

[neophytenate]

(This response is in English)

McMillan quotes a trader who said that the only good option to buy is an expensive one.

Of course this is overly simplified - LM points out that if one did this indiscriminantly, then one would be broke soon. The trader still had to filter for the right situations.

The point is that, in general, options are fairly priced and high IVs often preclude high SVs in many cases - but which ones?

 

[IluvVol]

Quote from atticus:

The buy-side lifting an offer = paying a premium to the fairval figure to the market maker, who receive this edge as a function of adding liquidity. Buy-siders pay the spread as a penalty for taking liquidity. Market maker's are concerned with spreading vol at edge, not with taking large vol-bets.

I don't know where it's written that low-vol begets a large move. It's spurious to make that connection. Vols trend/drift.

And I dont know how you at all addressed the OP's post.
I think the question at the heart of his post has to do with the fact that high IVs imply larger movements in the underlying (an expected more spread out distribution at option expiration) and therefore would from a pure intuitive standpoint make sense to buy the option either as a straddle or call/put and the opposite for low IVs.

My take on this is that options in the aggregated market (not talking about an individual trader's view) are pretty fairly priced. It means you obviously want to get something for your higher premium. What you in fact buy is the higher implied volatility with a higher prob of payoff. The opposite holds for low IV options. So, as with all in life you get what you paid for.

Of course on a micro level traders have views on the changes in volatility, such as beliefs in mean-reversion and the like, or they might have knowledge of future events that others dont (whether illegally or legally obtained). As the market as a whole includes traders of all kinds and with a variety of investment and trading approaches you will always see people willing to buy and sell the same option at least when it is about the "fairness" of the option premium. Hope this answers your question.

 

[Gravestone Doji]

My point is not what direction. I'm making the assumption that you have some idea as to which direction you feel the underlying will move. In other words I assume you have some bias as to which way it's future direction will be, be it from technical analysis or through stock screening, etc.

Let's say a company you've been following is going to announce earnings, yet IV in front-month options is relatively low. You expect a good report so you think there's a good chance it's going higher. But you're obviously in the minority, because option players (according to IV) are not pricing in any expected surprises.

Sure, you can buy those cheap calls but they're cheap because the market makers do not believe the underlying is going to move on the news and demand from other traders seems to indicate this as well. If they're wrong you stand to profit handsomely. But the consensus is you're the one who's out of line and likely to be wrong, not the options.

So my point is this: Is the time to buy options only when they're cheap? Is this something one should practice over and over again? Is betting against the pro's and floor traders, with the assumption that they've mispriced options because they're dead wrong on future volatility, a good strategy to employ?

Of course nobody knows what the future volatility will actually be. But according to the option guru's and books on the subject, you should employ buying strategies when options are cheap, as indicated by relatively low IV. But remember, someone is selling you that cheap option. That someone is probably much more in tune to what's likely to happen. So they set the price low to attract buyers. And don't think that the sellers of those cheap options don't know what the gurus say and what books on the subject tell traders to do.

Buying cheap and selling expensive sounds good. Maybe too good. That's my point. Because if a cheap option expires worthless, or looses most of it's value because your expected move doesn't materialize, (like IV was telling you) it wasn't cheap after all, it was very expensive.

 

[Gravestone Doji]

Quote from IluvVol:

I think the question at the heart of his post has to do with the fact that high IVs imply larger movements in the underlying (an expected more spread out distribution at option expiration) and therefore would from a pure intuitive standpoint make sense to buy the option either as a straddle or call/put and the opposite for low IVs.

Yes, that's exactly my point. Very well put. I know I presented a lot of questions but I'm not really asking as much as I'm pointing out these ideas that seem to make sense from, as you say, "<i>a pure intuitive standpoint</i>".

 

[atticus]

Quote from IluvVol:

And I dont know how you at all addressed the OP's post.
I think the question at the heart of his post has to do with the fact that high IVs imply larger movements in the underlying (an expected more spread out distribution at option expiration) and therefore would from a pure intuitive standpoint make sense to buy the option either as a straddle or call/put and the opposite for low IVs.

I was responding to the following:

Yet that's the message that option books and gurus are preaching; buy cheap options and sell expensive ones. I'm just wondering how wise it is to assume those who are on the floor everyday, making a market in options and hedging their positions, are dead wrong when IV is at extremely high or low levels. Maybe it's better to buy or sell options when IV is somewhere in the middle, near its norm? Or perhaps a punter should buy when IV is high, because according to the pro's and well informed, a move in the underlying is imminent?

It's not an issue of right or wrong. They're not in the business of taking vol-bets. They're far more concerned with relative / absolute vols.

SV tends to mirror IV in most cases -- the exclusions tend to occur around earning's season and major corp announcements. I have found very little predictive-power in a top or bottom decile IV.

 

[IluvVol]

Comments below...

Quote from Gravestone Doji:


Let's say a company you've been following is going to announce earnings, yet IV in front-month options is relatively low. You expect a good report so you think there's a good chance it's going higher. But you're obviously in the minority, because option players (according to IV) are not pricing in any expected surprises.

---> Well maybe there is no surprise. The point is not whether people think the report will be good or bad. That is already priced into the delta, the underlying. The question here is whether there is uncertainty in the market about the report. This drives implieds, nothing else.

So my point is this: Is the time to buy options only when they're cheap? Is this something one should practice over and over again? Is betting against the pro's and floor traders, with the assumption that they've mispriced options because they're dead wrong on future volatility, a good strategy to employ?

--->no, buying cheap options (i assume you mean low IV options) just for the sake of it will beed you to death fo sure. Options markets are not giving anything away for free ;-) Just always ask yourself WHY the market is pricing in low IVs, why is the market doing this or that. ONLY in very rare times are markets irrational, never let anyone tell you otherwise.

Of course nobody knows what the future volatility will actually be. But according to the option guru's and books on the subject, you should employ buying strategies when options are cheap, as indicated by relatively low IV. But remember, someone is selling you that cheap option. That someone is probably much more in tune to what's likely to happen. So they set the price low to attract buyers. And don't think that the sellers of those cheap options don't know what the gurus say and what books on the subject tell traders to do.

---> this should tell you that what you read was then probably not written by any GURU, an option veteran would NEVER tell you such nonesense.

Buying cheap and selling expensive sounds good. Maybe too good. That's my point. Because if a cheap option expires worthless, or looses most of it's value because your expected move doesn't materialize, (like IV was telling you) it wasn't cheap after all, it was very expensive.

---> you dont make money in options by buying cheap options and selling expensive options. You make money if you are long vol and vol goes up and you make money when you sell vol and vol trades lower. Not simple, but a simple concept which holds true

[/B]

 

[Gravestone Doji]

Quote from atticus:

There is very little predictive-power in a top or bottom decile IV.

I have to disagree. That's what the floor traders are hoping you believe. But if that were really true, then you could make a bundle because the top and bottom IV's would be ripe for attack if they indeed offered "<i>very little predictive-power </i>" My point is it seems to make more sense to believe that a top decile IV is a good indicator the underlying is unstable and future volatility is in the offing. Thus it may <i>not</i> be a good time to sell options, like the books and guru's say.