Hi all, I've been trading futures for a long time but want to diversify into options and have a couple of initial questions on IV. 1/ The IV displayed at each strike, as i understand it, is annualized, is there an online calculator etc to work out the expected move for the time remaining until expiration. Or is it just as simple as (IV/365)* Time to expiration? 2/ IV makes sense to me for ATM option, but i don't get how a strike price 10% away from current market price can have a similar IV to the ATM IV? For example, assume the market is trading at 100 with IV of 10% so we expect the market to trade between 90 and 110 over next year. But the strike price of 130 also has an IV of 10%.. how? That to me suggests the market expects the price to have a 10% move either side of a strike price 30% higher than where its currently trading. Wouldn't that mean the ATM strike would need an IV of 40% for both those things to be true? Hope that makes sense. Thanks Tom
This is a very simplified response. There are about 255 trading days in a year-I’m sure that is wrong, but close. The Square root of 255 is just under 16. An implied volatility of 16 is pricing in about a 1% move on average per day.
You are not going to believe this but they just kind of guess about the volatility. The major unknown in the BS equation is volatility. Volatility becomes what makes the formula work. You plug in all the knowns and then whatever it takes to get to the market option price is the implied volatility. You need to appreciate volatility but there is not a great degree of precision that goes into this variable.
OK, fine; Don Bright/ Daytrading used to be an option market maker+ noted options are made to be sold.Hope that makes sense, it does to me..................................................................But @ least you can control losses , buying options.
From memory, not looking at options chain: Re: 1 I believe many people do rough estimate in their head as the cost of the straddle divided by 2. This would give you the dollar amount of the expected move. For example if ATM call cost $5 and so does the put, the expected move would be $5. Usually the cost of ATM call and put is the same so the expected move would be the cost of that call or put. Re: 2 According to Black Scholes the IV should actually be same for all strikes. It’s the fact that often the IV is not the same that’s strange, and explained mainly by the tail risk. Only after 1987 market crash people realized they’ve been selling deep OTM options too cheap, so the options structure has changed to account for that tail risk, resulting in higher IV deep OTM and so-called volatility smile.
Think of the way that IV is derived from the BS model. Since it’s the only unknown, market just has to bring everyones best guess by trading and hence IMPLY what the vol is going to be. Let’s say the ATM put has an IV of 10. Is it too high or too low, can’t say until it has expired. Meanwhile the put ten strikes OTM has IV of lets say 15, which like you said, implies bigger move in the spot. This is where the way that IV is derived comes in. Since other inputs are known but IV isn’t, it’s derived from the price of the option and the other known inputs. Now the other inputs make the value of the put fall, but people are still buying the otm put relatively expensive (perhaps as a hedge, that in generally accepted theory creates vol. smiles), hence the higher IV. Think of a put like 4 std. away. With all the known inputs, the value should be close to zero, however, for example in case of some options, they are traded in min. 5 cent increments. If you wanted to buy this option, you would have to pay 5 cents for it, pumping up the IV into crazy numbers because all the other inputs suggest price near zero, but you just paid five cents for it so IV kind of like has to ’explain’ the crazy price. Hope that helps, and Robert already answered your first question so not going to add to that.
IV is set by the market maker of that option. If the market maker is buying a lot of options he will lower the IV, which lowers his prices, keeping him from buying more, while increasing the likelihood of the order flow for sales comes to him. If the market maker is selling a lot of options, he will raise IV, raising his markets, making sure that he doesn't continue to sell.
That is pretty close to the truth, but MM will also increase prices if realised vol has jumped, or if there are events in the near future which are likely to impact vol (eg Non farm, elections). GAT (Used to be an interest rate options market maker)
Yea, in practice I've seen them set a baseline volatility based on realized, events, etc and then would adjust their implied around the baseline vol as described via inventories.