That relates to a different type of margin. For instance, if we look at spot=100 and we take the 90 call for 10, that's similar to buying stock fully borrowed with 10% margin req. Again, not taking into account other options characteristics. If we'd do that, you'd have to buy the 90 put as well. ATM option would be 100% borrowed money, so no margin req... basically impossible. OTM calls can't be as easily related to just stocks on margin. Put/call-parity means any option can be replicated.
Yeah of course... that's why I said you should buy the put. But I don't want to go explain put/call-parity again and how it all works together... I've typed that stuff up too many times already in other threads... And then I also feel the need to explain how dividends come into play... and possible stock lending issues... and the fact when holding stocks gives you voting rights... and difference between interest rates... possible ownership issues in case of broker bankrupty... etcetc.. Kinda goes beyond the "Basic Option Question" thread title... we've already gone past that scope by now...
Implied volatility is subject to change. Supply and demand is a major determining factor for implied volatility. When a security is in high demand, the price tends to rise, and so does implied volatility, which leads to a higher option premium, due to the risky nature of the option. The opposite is also true; when there is plenty of supply but not enough market demand, the implied volatility falls, and the option price becomes cheaper. Most of us have a tendency to buy things at a cheaper rate and the same concept they apply while trading in options. Many traders generally look to buy options that are deep out of the money strikes, which are available at low premium. But the probability of getting that strike price in-the-money is very low. Since, we trade into options with a limited period to exercise our rights; one should prefer at-the-money or slightly out of the money strike prices as the probability of it getting exercised is high.
You couldn't be more wrong... The main factor in implied volatility is the expected near future realized volatility of the underlying... if everyone expects a higher realized vol the implied volatility of the options will go up, because the probability curve changes... which affects the options premium, making them more expensive. When a security is in 'high demand', it just means that that underlying will go up in price. It doesn't necessarily mean the options premiums/implied vols are going up. They might come down, depending on past and future expected volatility. Implied volatility also doesn't really have to do with the 'risky nature of the option(s)'... but to the risky nature of the underlying security/stock. In general, when there is a lot of supply in the underlying... the markets tend to fall, causing the implied vols to rise... so no, this isn't correct: "The opposite is also true; when there is plenty of supply but not enough market demand, the implied volatility falls, and the option price becomes cheaper."
Thank you for this explanation. It clarifies things for me nicely. I do have several questions: 1. So, IV reflects the expected future realized volatility but not the future mean (forecasted up/down) of the stock price? 2. Is that because the MMs always hedge so the actual price of the underlying is neutralized by the hedge? 3. If the price is any different, then someone can arbitrage and get a risk free return? 4. In that case, as a buyer of options, I am paying 1 standard deviation of the future expected volatility, so there is a 68% probability I am going to take a loss at expiration based on the collective wisdoms of the market? Regards,
1> Uhm... no, well... from the volatility as a number you can derive the expected $-amount of move of the stock. Can still end the month at the same price as it was, but that's volatility for you... up and down. 2> What do you mean by that? MM's hedge because they (and basically nobody for sure) don't know whether a stock will go up or down... 3> Yes, although in a volatility trade... I risk free returns aren't really there... unless you do more advanced things like dispersion... but still then it's not risk free. In general, is IV is too low... you should buy it and make more money on the gamma/scalping then you lose on the Theta... basically the gamma/theta ration is then in favor of buying. 4> Hmm... It all comes down to a daily expected move... If the IV is 19, your daily expected move for the duration of the options is about 1% (depending on the model, if you look at business days IV of 16=1%). The 68%/1sd thing comes from where the volatility predicts the stock will be within that 1sd. IV relates to straddle value. If you buy a 1-month straddle at IV 19 that's about 4.30% straddle value... so for a stock of 100, that's 4.30... so the 1sd is at 95.70 and 104.30... that's your break even point. But if you gamma scalp at the right times... you can get away with expiry at 100. I find that IV and straddle values are easier to understand when you look at short date options when an event is coming up. Say a 2-day straddle with earnings tomorrow. If the straddle =15%... it's a good guess that the earnings move is about that... at least you should expect that kinda move, based on the past and indeed collective wisdoms of the market.