Confused about IV

H

hcour

Guest
New to studying options, in my first read-thru of "McMillan on Options". (A great book, imo, and I agree w/the ET reviews stating this is good stuff to know whether one uses options or not. *Much* to be learnt from this here tome.) My intial interest is to use options as simple risk control. The other book I've read is Kaeppel's "4 Biggest Mistakes...". I understand HV well enough, the volatility of the underlying price movement, and I think I understand that IV, as McM puts it, is the future vol suggested by option prices. IV can also give one a sense of whether options are cheap or dear. OK.

McM cites the case of AMD and Intel in '94, when the latter filed against the former, it goes to trial, and the market awaits the outcome, so HV is low, understandably, since no knows what that outcome will be, but which should result in a good price move in AMD one way or t'other. This would be common sense, but McM says this pov would be furthered by the *high* IV of AMD options, which also makes sense as longs and shorts try to anticipate the outcome of the suit.

Kaeppel says that one of the biggest mistakes that traders make who use options as a substitute for the underlying, just buying calls or puts rather than going long/short the underlying, is to buy higher IV, relative to some timeframe, a year I believe is what he suggests. The reasoning being that the higher IV will probably have limited upside potential, as they are expensive, w/greater downside potential, as IV will cycle, revert to the mean, etc. So the high IV (expensive) option may not move as well w/the underlying (delta, yes?) as will the lower IV (cheap) option.

So in the Mcm example, high IV (and low HV) creates a potentially explosive situation, so the high IV is a positive. But in Kaeppel's example, the high IV is a negative. But they both seem to make sense. Is this seeming contradiction because of the differing circumstances? Still, I'm confused: If one were looking to go long the underlying on a breakout from a trading range, a low HV condition, but substituting buying a call via Kaeppel, then wouldn't a high IV suggest that the market was looking for a strong move?

Thanks,
Harold
 
*if* you could get a fill the moment the trading range was violated, then the high IV in the options could be "arbitraged" in a sense

however, I think the high IV in the options means the market thinks the underlying will gap, thus making it difficult to trade the underlying in the direction of the move (even if the move is strongly directional)
 
There's really no fixed answer because it depends on so many conditions.... but I'll give one case scenario.

High implied volatility denotes risk uncertainty in the market. If a stock has low historical volatility but high iv's, it's because certain news is about to be released which will presumably shake the underlying. These cases could be earnings reports, or quarterly reports, M&A activity, Fed announcements, etc. If you want to long an underlying but only want limited downside exposure, substitution with the calls can easily do that, but if those calls have a high iv, it could be costly. If they're front month, you have to worry about theta. If they're back month, you have to worry about vega risk. But if your estimation of the direction is correct, and the underlying does go up significantly beyond the implied volatility of the purchased option, then it doesn't really matter (unless your strike is way out of the money.) But if the underlying tanks, you will lose on your options regardless (unless iv spikes up even further like 9/11), but those losses will be limited, unlike simple long/short stock positions.
 
Harrold,

You're correct in saying that the two are talking about different circumstances.

That is, Kaeppel is, basically, saying that if you ignore IV analysis then you cannot trade options successfully, as volatility plays a major role in options. In fact, sometimes you can be 100% correct on the the direction of the move and still lose money, because you ignored volatility.

McMillan, on the other hand, is talking about specific situations when there is some significant uncertainty about the future price of the underlying due to some upcoming event, such as earnings, law suits, FDA rulings and etc. Then volatility plays a different role, so to speak. In those cases, options trade at extreme levels of IV in expectation of a significant move in the undrelying price. For example, have a look at APPX earlier this month. Front month options (JAN) were trading at IV levels of around 200%, because the FDA was expected to rule on its cancer drug.
Some people play these situations with long straddles/strangles and "hope" that the price move following the announcement will outweigh the cost of the straddle and IV crush (aka implosion), which comes right after the announcement. Others, take advantage of the IV skew that exists between the expiry months prior to the event..........There are many ways to play these kind of situations, depending on what you want to achieve.

Alex
 
There is nothing inconsistent in what the two writers are saying. Buying expensive premium is a long term losing strategy. But selling it is dangerous. Spreads remove some of the risk, at a cost. Different spreads have different characteristics. Probably your next read should be Natenberg, Options Pricing and Volatility. He explains this in great detail and shows how to evaluate different strategies.
 
Thanks for all the informed and interesting responses, especially Anseld and Alex, ya'll cleared that up very nicely for me. You guys really know your stuff.

Alex, you wrote:

"In fact, sometimes you can be 100% correct on the the direction of the move and still lose money, because you ignored volatility."

Ok, excellent, understood, that's what I though Kaeppel was saying. So, as I said, I want to use the most basic option strategy, which is simply to buy puts and calls in lieu of an outright position, as Kaeppel talks about. The reason I'm doing it this way is because I want to limit my risk while I become familiar w/trading futures markets and both you guys seems to affirm this way of using options as risk control.

So, basic questions:

As I understand it, the two things I need to pay attention to are IV and Delta, correct? The IV should be low, so the option is "cheap", and thus has better opportunity & potential to go somewhere. And Delta should be high, so I'm assured the option will move in step w/the underlying. Am I ontrack here so far?

How does one measure "low IV"? I believe Kaeppel suggest looking at the IV relative to a one-year timeframe. Would ya'll agree? Should I consider HV in this respect at all, or the HV/IV relationship?

My strategy is to swing-trade futures, holding positions for several days to several wks at the most. For this strategy I should buy ATM or near, which I believe McMillan suggests, and that these will usually have a high delta, correct?

AAA, you suggested "Natenberg, Options Pricing and Volatility". Now that I've (hopefully) clarified my objectives and strategy, do you think this would be a good book for this kind of basic approach to using options for trading futures?

Fascinating stuff, these options, and you guys are on top of it. As a lurker, I've found this to be one of the most helpful, generous, and dare I say, mature boards on ET.

Thanks much,
Harold
 
Harold,

Yes, you want to buy options that have a relatively low IV when comapred to past levels of IV (it can be 1 year or more if you like). You can also throw HV into the equation, to give you a more complete picture.

The Delta of an option depends on how much OTM/ITM it is. I.e. ATM options have a Delta of around 0.5, as options get more ITM their Delta approaches 1/-1, and as options get more OTM their Delta approaches 0. Delta is also affected by time.
Although Delta is important, what you really want is high Gamma, and Gamma is the highest when an option is ATM. Also Gamma of ATM options increases as the options get closer to expiry, so if you're betting on the move within the next few days then you want to buy options, which are the closest to expiry.

Alex
 
Quote from MTE:

Although Delta is important, what you really want is high Gamma, and Gamma is the highest when an option is ATM. Also Gamma of ATM options increases as the options get closer to expiry, so if you're betting on the move within the next few days then you want to buy options, which are the closest to expiry.
More...

But the opposite of gamma is Theta and so high gamma = high theta. If I wanted to go long options purely as a substitute to buying the underllying (e.g. buy & hold) I'd want a high delta and low gamma, i.e. DITM and far dated. Obviously I'd want low IV too if I could get it, but the deeper ITM you go, the less the IV premium is as a percentage of the option price.
 
Quote from Profitaker:

But the opposite of gamma is Theta and so high gamma = high theta. If I wanted to go long options purely as a substitute to buying the underllying (e.g. buy & hold) I'd want a high delta and low gamma, i.e. DITM and far dated. Obviously I'd want low IV too if I could get it, but the deeper ITM you go, the less the IV premium is as a percentage of the option price.
More...

That's true, you can use those as a substitute for the underlying, but Harold is looking for short-term moves and you get more leverage with short-term ATM.
 
Harold,

What exactly are you thinking of trading? You mention futures options and while the pricing theory (greeks..etc) is pretty much the same between instruments. One thing you really need to also look at if you plan on trading futures options with a directional strategy is the liquidity of these instruments. ES and NQ options for example have pretty wide spreads making it quite costly to trade these options.
 
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