Implied Volitility

[Robert Morse]

I'm not allowed to give trading advice, so I have to speak in general terms.

It is a mistake to think that higher premiums are a sale and lower ones are a buy. I have seen, over and over, traders make a lot of money selling low implied vol because the underlying was less volatile than expected and traders go out of business selling high vol, as the underlying was more volatile than expected.

In 2009, the traders that bought short term options on bank stocks at very high implied vols made $$mm. There are times when high is too low and low is not low enough. That is why I say you need to have some type of predictive process to make these decisions if you are going to enter these types of option trades.

 

[Philo Judeaus]

I'm not allowed to give trading advice, so I have to speak in general terms.

It is a mistake to think that higher premiums are a sale and lower ones are a buy. I have seen, over and over, traders make a lot of money selling low implied vol because the underlying was less volatile than expected and traders go out of business selling high vol, as the underlying was more volatile than expected.

In 2009, the traders that bought short term options on bank stocks at very high implied vols made $$mm. There are times when high is too low and low is not low enough. That is why I say you need to have some type of predictive process to make these decisions if you are going to enter these types of option trades.

Couldn't agree more with this post, spot on.

A great vol trader named Chris Cole once said "low vol begets lower vol, and high vol begets higher vol".

Vol is probably the most important "metric" in finance, besides variance (which is vol) and order-flow/volume. Its speaking to the market, telling us something. If vol is low its low for a reason. Whats the reason? Who knows and who cares, the real question is how are YOU going to implement a strategy that can extract some alpha from the low/high vol enviroment.

 

[Robert Morse]

Who knows and who cares, the real question is how are YOU going to implement a strategy that can extract some alpha from the low/high vol enviroment.

Bump!

 

[drm7]

From my understanding of Implied volatility (IV), high IV means the stock price will fluctuate in a wider price range. This is compared to low IV where the stock price will fluctuate in a tighter price range. Therefore, one would think if you are a option buyer, you would favour option that have a high IV so as to increase the probability of your chosen strike price being hit. Likewise, if you are a option seller, you would favour options that have a low IV so as to decrease the probability of the strike price being hit. However, it seems that the options buyers prefer options with a low IV and options seller prefer options with a high IV.

Most grateful someone can explain this logic to me.

You have to get the semantics right to fully understand how to analyze an option trade based on volatility:

IV is the expected volatility that is reflected in the option price. It is literally a plug figure in the option pricing equation. If you know the option price, the underlying price, the strike price, the interest rate, the dividend and the expiration, you dump all of those into a formula and solve for IV.

That doesn't mean that IV is "correct," though. It's just what the option market expects volatility to be.

What that means in your example is that a high IV stock does (theoretically) have a higher chance to hit a strike price, BUT, the option is more expensive. It is a mathematical fact! You are paying a premium to compensate the option seller for the volatility. The reverse is true for low IV stocks.

People who model and trade options using volatility put in a lot of work to find options that have an expected volatility that is meaningfully different from the volatility implied in IV. Once they find these mispriced options, they buy/sell the option (or run a complex combo trade, depending on which options in the chain are mispriced) and hedge out the underlying. It's a very tough, capital-intensive and computationally-intensive way to make a living.

 

[Matt_ORATS]

You have to get the semantics right to fully understand how to analyze an option trade based on volatility:

IV is the expected volatility that is reflected in the option price. It is literally a plug figure in the option pricing equation. If you know the option price, the underlying price, the strike price, the interest rate, the dividend and the expiration, you dump all of those into a formula and solve for IV.

That doesn't mean that IV is "correct," though. It's just what the option market expects volatility to be.

What that means in your example is that a high IV stock does (theoretically) have a higher chance to hit a strike price, BUT, the option is more expensive. It is a mathematical fact! You are paying a premium to compensate the option seller for the volatility. The reverse is true for low IV stocks.

People who model and trade options using volatility put in a lot of work to find options that have an expected volatility that is meaningfully different from the volatility implied in IV. Once they find these mispriced options, they buy/sell the option (or run a complex combo trade, depending on which options in the chain are mispriced) and hedge out the underlying. It's a very tough, capital-intensive and computationally-intensive way to make a living.

Well said drm7. I was a market maker and backed traders on the floor of the Cboe. We used methods to forecast volatility and would put traders in pits where the forecasts tended to be near or above what implied ran for particular stocks.
Now, my firm, ORATS sells forecasts and volatility information. We also have a backtester. After running millions of backtests I can agree with the earlier comments about the absolute level of implied volatility and say it this way for extreme cases, "they don't get the IV high enough and they don't get the IV low enough". What I mean by that is at the edges of the IV range, the returns are counter-intuitive. At much higher than normal levels of IV, often the HV is still greater for a time, and vice versa.

 

[TheBigShort]

We used methods to forecast volatility and would put traders in pits where the forecasts tended to be near or above what implied ran for particular stocks.

Cool. It sounds like you guys were running a long vol book. Would you mind elaborating a bit more about your strategy and why you looked for long vol opportunities rather than short vol?

 

[Matt_ORATS]

Cool. It sounds like you guys were running a long vol book. Would you mind elaborating a bit more about your strategy and why you looked for long vol opportunities rather than short vol?

Our strategy was to be long units, not necessarily long vol. By units I mean for example if you were long stock you would be short 1 downside unit. If you had a ratio call 1 x 2 (+1 -2) you would be short one upside unit. I was the backer of other market makers and by being long units you could limit the risk. I wanted to make our profit on the bid-ask spread, not on delta or vol positions. You had to look carefully to find stocks where the IV was not lower than the HV. We used a tick volatility that would simulate gamma scalping and turn that profit into a HV which we would use with other factors to forecast upcoming volatility.

 

[VolSkewTrader]

The VIX is getting low again and I'd be looking to get long vol if the cash index got to 10 or below. Not a big fan of inventorying option premium, but what long vol position do you guys think has the highest upside/least downside risk when the VIX gets historically low? Choices:

1. Buy VIX futures

- Trades at a premium to the cash, can only replicate the cash instrument through the OTC variance swap market
- Lose money on the roll yield due to unfavorable VIX term structure​

2. Buy VIX calls

- Expensive like SPX puts​

3. Buy SPX/SPY OTM or winger puts

- Most crowded trade, buying the skew at its steepest point​

4. Buy exceptionally cheap SPX calls and fully delta hedge them

- Vega and vol exposure disappears on a large sell-off​

5. Sell 1x2 SPX/SPY put ratios, or sell 1x2 VIX call ratios

- Overpaying double on the steep skew/slope​

6. Buy straddles or strangles in SPX/SPY/VIX

- Get eaten alive by theta, even if vol has bottomed out​

7. Buy straddles or strangles in SPX/SPY/VIX

- Get eaten alive by theta waiting for the big move, even if vol has bottomed out​

8. Buy one or more of the VIX-related ETFs: VXX, TVIX, UVXY, etc.

- Never get what you expect from leveraged ETFs


​

 

[Wheezooo]

When I thought vol was too low...

9- Load the boat, dynamically hedge daily attempting to make back a little more from gamma than you lose on theta (which if you are correct, and vol is too low, you should be able to do). Wait for the pop.

Preferably I'd still go 1*2 puts and 1*2 calls as it pains me to own the ATM, and this way if I am right, I move towards my longs and get longer vol as it's popping. God how I love those 2nd and 3rd derivative moves such as vega delta on vol change.

 

[Matt_ORATS]

The VIX is getting low again and I'd be looking to get long vol if the cash index got to 10 or below. Not a big fan of inventorying option premium, but what long vol position do you guys think has the highest upside/least downside risk when the VIX gets historically low? Choices:

1. Buy VIX futures

- Trades at a premium to the cash, can only replicate the cash instrument through the OTC variance swap market
- Lose money on the roll yield due to unfavorable VIX term structure​

2. Buy VIX calls

- Expensive like SPX puts​

3. Buy SPX/SPY OTM or winger puts

- Most crowded trade, buying the skew at its steepest point​

4. Buy exceptionally cheap SPX calls and fully delta hedge them

- Vega and vol exposure disappears on a large sell-off​

5. Sell 1x2 SPX/SPY put ratios, or sell 1x2 VIX call ratios

- Overpaying double on the steep skew/slope​

6. Buy straddles or strangles in SPX/SPY/VIX

- Get eaten alive by theta, even if vol has bottomed out​

7. Buy straddles or strangles in SPX/SPY/VIX

- Get eaten alive by theta waiting for the big move, even if vol has bottomed out​

8. Buy one or more of the VIX-related ETFs: VXX, TVIX, UVXY, etc.

- Never get what you expect from leveraged ETFs


​

Good question VolSkewTrader

What to do now with the VIX this low.

The VIX below 12.5 has only triggered our backtester 18 times.

I have backtested the strategies you mentioned as follows.

1. Buy VIX futures if VIX under 12.5 and sell if gets above 15, 17.5, 20 or 25.

For starters if you were able to buy the VIX cash when it fell under 12.5 and sell when it went above 15, 17.5, 20 or 25 you would do very well. Here are the results for the best of those selling when the cash VIX went above 17.5:

Being unable to buy the VIX cash, what is the best alternative? I can list out some alternatives if people are interested but the returns will not be nearly this good because what VolSkewTrader mentions:

- Trades at a premium to the cash, can only replicate the cash instrument through the OTC variance swap market

- Lose money on the roll yield due to unfavorable VIX term structure


2. Buy VIX calls if VIX under 12.5. 30 days to expiration (DTE) 30 delta calls held to expiration does poorly with a -13.07% Annual Return. Our annual returns are based on profit/stock price, slippage and commissions are considered as explained here.

3. Buy SPY OTM puts if VIX under 12.5. I chose a long term 1-year put with a low delta of .05 returned a -0.04% annualized return.

4. Buy SPY cheap calls and delta hedge. I backtested buying 6-month OTM 0.05 delta calls, delta hedging every 5 days when the VIX was under 12.5 and exit the position when the VIX went above 17.5. This returned -0.03% annually.

5. Buy a SPY 1x2 put backspread. I used a short 0.40 delta put and two long 0.20 delta puts at 45 days to expiration in the backtest, and entered the spread when the VIX was under 12.5 and held the position to expiration. The strategy returned -0.6%.

6. Buy a SPY straddle 30 DTE hold to expiration when the VIX goes below 12.5 returned 0.27%.

7. See #6

8. Buy UVXY when the VIX goes below 12.5 and exit when the VIX goes above 17.5 returned -4.01%.

So my choice would be to find the best VIX future to buy in this scenario.

If you want to see these backtests and run some of your own, signup for a free-trial and message me. I can send you links to the backtests which you can edit or run new ones.