Simple options IV test

Discussion in 'Options' started by JJacksET4, Aug 5, 2009.

  1. I made this "Simple options IV test" to see how much confusion there really is over what IV is. I have been concerned about what seom people seem to think IV really is.

    Please read the questions and give me your answers - they are simple multiple choice questions and I think they are all really quite easy (one of them could have a small trick to it).

    If you can't quickly get the correct answer to each one, I would suggest studying options and IV more. These answers aren't just the ones I think are correct - they are like 5+5=10 - not really debatable unless you want to get into questions of life itself, etc. :)

    You can just list your answers or you can list an explaination of what you think if you want to.

    Bonus points to those who catch the potential trick, but they really are quite straight forward and I would hope they are about Options 102 and IV 101 level. I would hope most traders here and certainly the resident experts would get these very quickly.

    For the purposes of these questions, I will use 2 fictonal stocks - Stock A and Stock B. They were both IPOs about a year ago and closed the first trading day at $50. They also closed today at $50.

    They don't pay dividends and don't intend to in the future. Assume all option contracts are standard and cover 100 shares. Otherwise, don't assume any info given for one question is relavent to the other questions. We don't know what market sector these stocks are in (i.e. financial, industrial, etc.)

    Please don't bash me too much if I might have made a typo or something. This was a lot to type up :)

    Here are the questions:

    Question the first:
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    Stock A as you know was at $50 and is still at $50 - a 50 Strike Call for 3 months away lists at:
    Bid = $600/Ask = $610/ Last = $605. The contract volume today was 100. You don't know any more details about the price of Stock A in between the IPO and now and you don't know any volume or options volume info or anyting about earnings dates.

    Stock B as you know was at $50 and is still at $50 - a 50 Strike Call for 3 months away lists at:
    Bid = $300/Ask = $310/ Last = $305. The contract volume today was 100. You don't know any more details about the price of Stock B in between the IPO and now and you don't know any volume or options volume info or anyting about earnings dates.

    Which option contract has a higher IV:
    A. Stock A - 50 Strike Call
    B. Stock B - 50 Strike Call
    C. Not enough info to determine.
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    Question the second:
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    Stock A IPOed at $50 and is still at $50. However you look at the prices in between and the stock has been stable - between $42 and $58 - never more or less.

    Stock B IPOed at $50 and is still at $50. However you look at the prices in between and the stock has been very volatile - as low as $12 and up to $110 and has moved way up and down quite
    a number of times.

    Both stocks have a 50 strike call 3 months out. Which one will have a higher IV?
    A. Stock A - 50 strike call
    B. Stock B - 50 strike call
    C. Not enough info to determine.

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    Question the third
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    Stock A IPOed at $50 and is still at $50. You don't know the price history in between, but you see the ave daily volume on this stock is very large (say 25,000,000). Also, all of the options
    are very active and have large Open Interests.

    Stock B IPOed at $50 and is still at $50. You don't know the price history in between, but you see the ave daily volume on this stock is fairly low (say 400,000). Also, the options are not very active with near the money options trading a few contracts per day and having around 50 to 100 Open Interest.

    Both stocks have a 50 strike call 3 months out. Which one will have a higher IV?
    A. Stock A - 50 strike call
    B. Stock B - 50 strike call
    C. Not enough info to determine.

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    Question the fourth
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    Stock A IPOed at $50 and is still at $50. You don't have any info on price history, but you see the last 3 months HV (historical volatility) is 60. Also, you find out they have earnings coming
    in 2 weeks.

    Stock B IPOed at $50 and is still at $50. You don't have any info on price history, but you see the last 3 months HV (historical volatility) is 30. Also, you find out they had earnings about 2 weeks ago and their next earnings is 2 1/2 months out.

    Both stocks have a 50 strike call 2 months out. Which one will have a higher IV?
    A. Stock A - 50 strike call
    B. Stock B - 50 strike call
    C. Not enough info to determine.

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    I will post the answers and some explainations later tonight (prob around 9PM PST). After that I may not get back to respond until later tomorrow.

    Thanks,

    JJacksET4
     
  2. You have waaaaay too much time on your hands

    :D
     
  3. Not really - I just type quickly :)

    JJacksET4
     
  4. Here are my answers:
    1. A
    2. C (or B - see explaination)
    3. C
    4. C (A could be considered - see explaination)

    I realized after reviewing these that 2 of them might not be crystal clear. Questions 2 and 4 are really C, but if someone answered them as B and A respectively I could understand that.

    Question the first:

    The answer is clearly A. The options contract shown for stock A has a larger IV then the one shown for Stock B. We know this even if we don't know what the IV is, what the HV is, what the stocks have done, when earnings are coming, stock or options volume, Options open interest, what other option contracts in those stocks are priced at, etc, etc, etc. None of that matters! The IV is simply a calculation that shows the relative cost. Since each stock is at $50 and they are Calls with strikes of $50 and the time is the same, the contracts are standard, etc. we know for sure that A is the correct answer.

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    Question the second:

    If I was a teacher, I would probably be a nice guy and accept either B or C for this one. B is clearly the one that would most likely have the higher IV since it has moved wildly in the past.

    However, a few factors could cause A to have a higher IV for the 50 strike call:

    1. Even though A hasn't moved much, it COULD have a huge IV if for example they had a make-or-break the company type of FDA approval or decline announcement coming before the option expired.

    There could also be other specific items could also cause a company to have a huge IV even if the stock hasn't moved much yet.

    2. Even though B has been volatile, something could have happened recently that reduces it's likely movement in the future - i.e. maybe it was at $40 and then just a day or 2 ago got bought out at $50 - pending final approval it might hover around $50, just moving a few cents a day - that would kill the IV if people assumed now the stock would stay around $50. Also, it could be something like they were mostly an internet company that lived on huge debt, but a few days ago they sold that division off and went into selling basic food products or something - now it could be expected that B won't move so much in the future.

    Again, this shows the IV is the volatility that is being implied in the specific options price at the specific moment (based on bid/ask or last depending).

    This was the slightly sneaky question as the answer might at first appear to be B, but really C is more correct as you can't say for sure B would be higher. I would agrue that A is incorrect even if stock A could be more volatile, because there is really no way a person could be sure of that and there was no evidence given that the IV of A would be higher then B.

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    Question the third:

    The answer here is clearly C. Stock volume, options volume and Open interest simply cannot be used to calculate IV and therefore A or B is incorrect.

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    Question the fourth:

    The answer here is C. HV (Historical Volatility) and earnings dates also cannot be used to calculate IV. Yes, a person could guess that A would probably have a higher IV, but what if stock B
    is awaiting FDA approval, etc? Actually, I guess a person could make a case that this is like question the second in a way - A seems right at first, but a person just can't calculate IV based on
    HV, earnings, etc, etc.
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    Mostly I wanted to show that IV is a simple calc where you need to know the stock price, strike price, option price, put or call, days to expiry and in some cases dividends and risk free interest rate.

    Knowing HV, earnings dates, past stock movement, stock volume, options volume, open interest, etc. not only doesn't help calculate IV, but cannot even be used really. Of course, a person could guess that a stock with a high HV and earnings coming would have a high IV, but it isn't guaranteed.

    JJacksET4