Why are auction market prices based on volatility?

[stepandfetchit]

Below is a 3-D Scatter plot with a dot for the Mid-price derived IV for SPX PUT options a couple minutes ago. The regularity of the graph, may provide insight as to why one may use it to determine pricing! --

While it may be difficult to see, the color of the dots are as follows:
1) Red: The Mid-point price derived IV for an option with NO trades (volume ==0)
2) Green: The Mid-point price derived IV for an option with volume > 0.
3) Yellow: The TOS Individual Implied Volatility value.

 

[sle]

It's actually pretty simple. Auction market is supposed to help determine where the final price will be with high probability. Since there is a clean, non-parametric way to get an implied price distribution from option prices, it's only natural to use them. Implied volatility, which is highly model dependent, never enters the equation.

 

[stepandfetchit]

A stock is trading in a $20 - $21 range. Buy $20, and sell a $21 call. Call premium = Stop loss. If the market is rising, how does the rate at which the call is losing value compare to the present directional profit being earned? Can a profit be squeezed while paying for the risk with insurance?

I don't see a correlation between your example Vertical Spread and IV based option pricing!
To understand the behavior of the vertical spread you reference:
If you have access to TOS, the platform I am familiar with, you can use it's Analyze tab (or use ThinkBack) to tweak price and time to observe how the option pricing is expected to change. This may help you to get your arms around some of the dynamics. (the first order effect will generally be delta {option price change as a result of underlying price change}). DTE is a big factor as it impacts decay of the extrinsic value. Volatility changes will also have an impact. ---
For an example, I grabbed GLW, which was trading in the range you mentioned a while back. Below is the PnL graph of your trade as GLW priced moved around, then finally above the upper range. This is from ThinkBack entering the trade on 6/7/16 after it bounced off the $21 upper resistance.

 

[TradeCat]

Read five books on Options Greeks, keep seven colorful charts open on no less than three monitors, lease seats on three exchanges, brag about your imaginary accomplishments on an anonymous elite forum and ...

VOILA!

you're rich

 

[sle]

Read five books on Options Greeks, keep seven colorful charts open on no less than three monitors, lease seats on three exchanges, brag about your imaginary accomplishments on an anonymous elite forum and ...

As opposed to read nothing, know nothing but have a loud opinion about everything. "Dude, do you even trade?"

 

[freedomshark]

I don't see a correlation between your example Vertical Spread and IV based option pricing!

If $21 puts and calls cost 50 cents whomever sold the contracts makes $100 per contract within this $1 band at expiration, opposite intentions for the buyers.

Are these debit/credit premiums balanced into present value with bid/ask or ebb and flow based on IV creating future battlegrounds for long vs short volatility?

 

[stepandfetchit]

Are you aware, that with each post, you are altering your statements considerably? (a moving target). Prior example: was buy $20 strike call, sell $21 strike call. Now you are referencing $20 strike Call and Put assuming(?) both are priced at 50cents? Seems that the "specific example" approach is NOT working out.
Reading between the lines, it would seem you may want to study the basics of options, to get a better understanding. Natenberg's "Option Volatility & Pricing" is one such source that may help. There may be better sources.

 

[freedomshark]

Are you aware, that with each post, you are altering your statements considerably? (a moving target). Prior example: was buy $20 strike call, sell $21 strike call. Now you are referencing $20 strike Call and Put assuming(?) both are priced at 50cents? Seems that the "specific example" approach is NOT working out.
Reading between the lines, it would seem you may want to study the basics of options, to get a better understanding. Natenberg's "Option Volatility & Pricing" is one such source that may help. There may be better sources.

Unfortunately, a) I'm color blind, and b) don't have access to my platform, but c) will check out that book. Thank you for your help.

 

[freedomshark]

There are debit/credit transactions that occur in the present based on an assumption about the future. How do those affect the current market in relation to the IV (and create opportunity)?

Looking for the simple answer here, not for ease but rather lack of brain power :/

FS

 

[stepandfetchit]

FYI: The colors on the 3-D plot are not really important. I think one COULD make a career out of developing a better understanding of Implied Volatility, and THEN may not be able to profit from that understanding. However, IMHO: Understanding IV better can help avoid many "sucker bets", and aid in understanding when someone is feeding you BS.