Understanding Implied Volatility

B

Blue_Bull

Hi everyone,

I am having trouble understanding IV. I realize it is one component of the price, and that it's the component that often screws over n00bs who correctly predict the move of the stock but still lose money.

For example, the BAC 20 Calls have an IV of 0.37. (http://www.crimsonmind.com/options/QuoteOptionsQM.aspx?qm_page=66039)

I can see that, in the past 6 months, the IV has been much higher - as high as 2.0.

So, I'm assuming that said drop in IV is part of the reason my BAC calls have lost a ton of value.

My question is: how can I use IV to determine if an option is "cheap," and does the IV tell me what kind of move is "price into" the option?

Also, what kinds of moves cause IV to go up or down? Based on some threads I've read, if a stock is rising, then pulls back, the IV on the call option will drop on the pull back, but might not rise again if the stock rebounds?

Thanks, and happy new year to all!
 
High demand for a call option would bring the IV up.

For example Goldman Sachs says, hey GE 22 calls for December are a steal, buy now before its too late.

Demand rises as the noobs get lead to slaughter and the Market Makers take advantage which pushes up the IV while the lemming are getting lead to slaughter.
 
Your time frame is important. When earnings or other announcements are approaching, you may find calls being bid up for a short time and volatility rising also. But, over longer time frames, generally speaking, price and volatility tend to move in opposite directions. This is one of the reasons that buying calls is such a difficult gig.
 
Quote from dmo:

I created and posted a 45-minute video that explains IV and the logic behind option pricing at http://masteroptions.com/?p=3 It's free and if you watch it you will have a much better understanding of how it all works.
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Thanks, that was a really really good explanation!

I have some follow up questions, dmo:

1) If I am looking at the volatility view in OptionsXpress (this view shows all the strike prices for a particular month, and the IV of each option at that strike price) - what does it mean if one strike, for example the Ford 8 Call, has a higher IV than the Ford 9 Call? (It's about 55 and 51, respectively) Is that to be expected?

2) The IV and historical volatility of Ford have both been much higher than the ~50 that the February calls are currently going for. I assume that means that the options market is not pricing in a large increase for Ford?

3) Finally, what's your take on the volume and open interest? I've heard some people say that a spike in volume relative to open interest is a bullish signal?
 
Quote from Blue_Bull:

Thanks, that was a really really good explanation!

I have some follow up questions, dmo:

1) If I am looking at the volatility view in OptionsXpress (this view shows all the strike prices for a particular month, and the IV of each option at that strike price) - what does it mean if one strike, for example the Ford 8 Call, has a higher IV than the Ford 9 Call? (It's about 55 and 51, respectively) Is that to be expected?
More...



Theoretically, all options on Ford should should trade at the same IV. After all, they all have the same underlying, which has a single volatility.

But in reality, IV is just a measure of the demand for an option. So if option A has a higher IV than option B, that means there is more demand for option A than for option B.

In most option contracts, the options at each strike trade at a different IV than options at other strikes. This phenomenon is known as "the skew." Typically, in stocks, the lower the strike, the higher the IV. The higher the strike, the lower the IV. There are exceptions, but this pattern generally holds true.

What is the reason for this pattern? Opinions differ. I would say it is a function of portfolio insurance. The lower the strike, the more valuable the puts of that strike are as insurance against a crash in the underlying, therefore the higher the demand.
 
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