Quote from Maverick74:
Yes, IV is mean reversion but that is not saying much unfortunately. To understand volatility you have to understand how it lives and breathes. Also lets make a distinction here between IV on indexes and individual stocks. There is a big difference. For individual stocks IV does not necessarily correlate with stat viol. I had this argument with Don. It's a very common misnomer. I would almost go as far out to say that stat viol has very little correlation with implied viol. If implied viol was tied to stat viol let's say 100%, then implied viol would be very mean reversion and very easy to trade. However implied viol has a risk component added to it. Implied viol is actually in my opinion more of a risk meter per say.
Let me give you an example. Say stock XYZ is trading at $50 a share. It has a stat viol of 35 and implied viol of 30. Let's also say that the implied viol is in the lowest 1/10th percentile of its implied viol range over the past year making the options look really cheap. Let's also say that stock XYZ is very strong in fact trading at it's 52 week high. It has been in a steady uptrend all year. Well the primary reason why viol is so low is because there is very little risk in this stock. It's very strong and it just keeps trending higher therefore the premium is pricing in very little risk. Say you were to buy these options because of how cheap they are and figuring that viol is mean reversion you decide to buy some long term options on XYZ. Let's also say you are buying straddles since you don't know or don't want to predict the direction of the stock. Well here is the problem you have. Even if the stat viol on XYZ increases the implied viol will more then likely continue to go lower. Why? Because as the stock goes higher the risk is less and less. Also there is a mathematical property at work here and that in simple terms, if the range of the stock stays the same as its rallying, the actual stat viol will drop as the price goes higher. So as long as this stock keeps making new highs and it could stay in an uptrend for years, then implied viol is not going anywhere.
Also something else to add here that many good option traders forget about it, is the relationship vegan has to time. So let's say you buy options that are 6 months out to get a lot of long vegan. And you wait and wait and the stock just keeps going higher. Well, 5 months from now suddenly the stock is downgraded and it starts to come in. Well, you have a pretty bad situation here. Because, the implied viol may have come all the way in to 20 now from 35 so you already took a hit on that but now all your vegan is gone. Why? Because vegan decreases gradually with time. Now your position is ready to capitalize on vegan but you have no vegan left. Instead you have a lot of gamma and a lot of theta. So now your position will gain nothing from the increase in viol but your bleeding profusely with the high theta now. The only thing you can do to save yourself is to hold on to your neg deltas and let your gamma work for you. But then you run the risk of the stock snapping back up and killing you.
BTW, the same scenario plays out on the downside just the reverse. As a stock is falling and the viol is really high, as long at the stock stays in the downtrend, the viol will keep ticking up. It might be statistically overpriced as hell but it's going higher. Again, the same math applies, if the range stays the same all the way down, the stat viol is going to expand every tick on the way down.
So you can understand now why the vix keeps dropping. It's dropping because the mkt keeps going higher and higher and there appears to be less and less risk in the mkt. If the mkt stays in this uptrend for another year lets say, then the vix could go all the way down to 10 or so.
So this creates somewhat of a dilemma right? By actually making predictions in viol you are actually indirectly making predictions on the underlying direction as well or at least you should be.
Back to the relative viol question. As an off floor trader who can pick and choose which options you want to buy and sell, by always buying options that are cheap and by that I would say options where the underlying is weak and not strong but viol has not caught up to it yet and vice versa selling options where the premium is high on strong stocks, you will then hedge yourself much better then just buying cheap viol or selling expensive viol.
I hope I did a good job of explaining to you the concept of volatility. i have met many many option traders and I find that maybe no more then 2% to 5% tops really understand volatility.
It's funny there are so many quant guys out there that get paid so much money to create viol models that I think are so worthless.
If you have any other questions, let me know.
