Is IV totally objective?

Discussion in 'Options' started by Eliot Hosewater, Jul 31, 2006.

  1. I got into a discussion on another forum where a guy stated that the MMs can manipulate IV, for example going into an earnings announcement.

    I thought it was more of a passive number, derived from an options pricing model.
  2. The implied vol is a derivation of $premium. It isolates the volatility and expresses it in a meaningful way. Knowing the premium of an option tells one very little about it's characteristics.

    Getting hung-up on absolute values, top/bottom deciles is a waste of time. Understand that the demand for premium will dictate the IV; not the demand for absolute vol-lines. A $4.00 bid at 50% vol may seem rich, but a $4.00 bid becomes 70% vol in two weeks time if spot is unch.

    Implied vol carries convexity akin to a deep otm option. Convexity demands respect.
  3. Aside from the convexity of implied vol and the consequences that carries, here are some other thoughts:

    Market makers don't have a dial that they turn to make IV go up and down.

    Yes, Eliot you are right that IV is a number that comes out of a model but you may be missing the point.

    When you are buying and selling options you are buying and selling volatility. The $ amount is virtually irrelevant. I believe OTC they still quote b/a in terms of IV.

    Market makers have to be defensive - they need to defend their book. The general idea being to make their money on the b/a spread through volume. As more speculation and hedging occurs during the build up to an earnings announcement the IV will get bid up - demand to buy that volatility. It would be folly for a market maker to make a less defensive market without undue risk exposure to themselves.

    Can the market makers manipulate IV (through controlling the b/a)? It's possible...but that would mean they need to know in advance just like you what is going to happen after earnings.

    The IV crush is often met with a large move in the underlying that is greater than was implied.

    So yes, the market makers might have been laughing at the near 0% move of GOOG after earnings but they may well have been crying after YHOO!

    2 cents.

  4. Thanks for the replies.

    It sounded like the guy was saying that the MMs DO have some kind of dial to turn up the IV if they wanted to increase the premiums. Maybe I misinterpreted what he said.
  5. Perhaps you could ask the guy how the market makers benefit from turning the IV up.
  6. Good idea.
  7. no , its vise versa
  8. Yeah, that's what I was trying to tell the guy, but he insisted that the MMs "tweak the IV" (his words).
  9. I watched the IV of WFMI options rise all day, peaking at the close just before earnings after the close.

    'they' will then kill the vol starting from 9:30-10am tomorrow