How do you tell if implied volatilty of an option is high? I know that the higher implied volatility is the more expensive the option but am confused on how high is high. 100%? 200%?
1) You can look at the history of whatever you're trading to get an idea of absolute and relative levels. 2) You can look at related markets to get an idea of relative levels.
To give you an idea, consider this: If a stock has options with an implied volatility of 100, that means the expectation is: approximately two out of every three years the stocks price will double. Now, that's volatile! Mark
calculate the the IV yourself and back into the interest rate used in the IV on your screen. It's the likely culprit if you feel the IV you see it too high.
I look at the historical IV at this website. This is the best way to analyze. During the recent market problems you could see that IV was very high and that selling puts or calls would make you a lot of money because the prices were so inflated. I would say first look at historical IV and see if that works for you; it does for me. http://www.ise.com/WebForm/md_livevol.aspx?categoryId=124&header3=true&menu1=true
Are you serious? Unless a trader sold those 'inflated' options at the top, he got destroyed. The market volatility exceeded the option implied volatility - and this time around the premium buyers came out way ahead. And that's especially true because we had big moves higher and lower. I am not a premium buyer, but to tell someone that selling options is a good idea - just because the premium is 'high' is poor advice. But you will learn that the hard way if you follow your own advice. Here's better advice: 1) Don't sell naked short options 2) Sell spreads to limit risk (yes, it reduces reward) 3) Don't sell more spreads than your comfort zone and pocketbook can tolerate. 4) Manage risk carefully. Mark
I've always understood that you should compare the IV with the historical volatility of the same contract.
Let's assume for a moment that all the assumptions on which pricing models are based are correct, and that if you feed your model the correct information, it will give you the fair price of an option. All the inputs are obvious except one - volatility. Which volatility should you use? The volatility over the last 3 days? Ten days? The "correct" volatility to use is actually future volatility - the volatility that will exist between now and expiration. The only problem is - you don't know what that will be. So you could use your best guess, OR you could use the volatility that the market is currently using - the implied volatility. If you think that the volatility between now and expiration will be greater than the current implied volatility, then it is your opinion that options are currently underpriced. In that case, you should buy straddles. If you think options are currently overpriced, then by all means, sell straddles. But if you don't have a strong opinion about future volatility, you use the volatility that the market is currently implying - the implied volatility. If crude oil 60 calls are trading at 85% IV and the 61 calls are trading at 90% IV, then based on historic patterns the 61 calls are overpriced relative to the 60 calls. That's a much more concrete - and useful - standard to use than comparing the IV to the historic IV.
What is the practical use of this information? In other words how to apply this knowledge in practice?