What is IV?

ondafringe · Sep 17, 2021

MrMuppet said:
To answer @morganpbrown 's original question I try to make a very dumbed down explanation. Many options veterans may jump on me for this but bare with me, ok?

So the most important thing for understanding options is the fact that you can REPLICATE the options payoff through trades in the underlying. Let's make a simple example:

Let's say a stock is at 100$, you are bullish and want to go long.
You buy 50 shares and install the rule that every time the stock moves 1$ you buy or sell shares in a decreasing manner as the stock moves away from 100$. For every 1$ move away from 100$ stock price you trade 1 less share. You start with buying 10 shares at 101$ and selling 10 shares at 99$, you buy 9 shares at 102$ and sell 9 shares at 98$ and so on.
You will do this over 30 days and then stop, no matter where the stock price is then.

Let's say you are right and the stock goes up to 102$, so your original position of 50 shares is now 69 and stock continues to rise. at 107$ you have 99 shares.

The number of shares you have is your delta and the difference between the current add and the next one is your gamma, which is one share (delta) per 1$ move. Voilà, you replicated a 100$ at the money call option with 30 days to expiration.

Stocks rarely go up in a straight line, and the problem that results from this is that your position is always the highest the more the stock moves in your favour, so you lose more, when the stock retraces.

Let's mix this up a bit.

You start at 100$ with 50 shares. Stock goes to 101, you add 10, it goes to 102$, you add 9 shares, it goes to 103$, you add 8 shares and now it retraces to 102$, where you will sell 8 shares.
The stock goes up to 103$, you add 8 shares again. Your position is 77 shares just like before the retracement, but you have lost 8sharesx1$ = 8$ on the way. The stock keeps on trucking to 107$ without any further retracements after that.

It will be intuitive that the more violently the stock moves back and forth during those 30days the more you will lose. When it goes from 100$ to 105$, back to 102$ before it goes to 106$, the losses you make due to the fact that you buy high and sell low will be higher comparet to a stock that goes from 100$ to 100.20$ to 100.10$ and back to 100.50$.

Still with me? Fine.
The losses you make during the stocks path to target are comparable to the premium you pay for an option.
In the first example we replicated a 30 day 100$ call option that had 8$ premium, as we lost 8$ on the way.

When the stock moves more violently aka is more volatile (or it's "average daily returns are higher"), you lose more, so you pay more premium and vice versa.

With that info fed into our brain, we can go ahead and talk more about volatility:

The examples I gave above generated returns through realized volatility. Thats the volatility the stock actually had during those 30 days. You can calculate it yourself in excel.

Back to options. Let's say the 30day100$ option for our stock in the first example costs 10$. Without crunching the numbers we know that the option is more expensive than our replication by trading shares.

So the option IMPLIES a higher volatility and if we replicated it via trading the stock and sold the option short, we would have made a 2$ profit.

Now to a more sophisticated explanation:

In order to compare nonlinear instruments, you need a common denominator. And some dude figured out, that you can take the options price, add the stock price, time to expiration, option strike to a formula that converts the options $ premium into a volatility figure...because that is the driver of all options premiums.

You cannot trade annualized interest rate of a 3m Short Sterling contract, but you use annualized interest rates to compare that 3m contract to a 10y treasury contract. It's just a math concept. So is implied volatility.

The BS formula is NOT a model that tells you how options should be priced according to the stocks historical volatility. That's how LTCM blew up.
Instead it is a mathematical framework that allows you to compare apples to apples aka compare a 60 day 20 delta option to a 10 day 50 delta option.

Options are driven by supply and demand and that ALWAYS comes first, NOT the volatility figure. You do NOT ask yourself why a 10d 5 delta option trades at 80 vols although realized 10d vol is at 20.

However you ask yourself how you can capture the 60 vols difference as a profit and at this point you speculate.

On the one hand you have a known return distribution which is implied by the options price, on the other hand you have an unknown return distribution which will be realized by how the stock moves during the next ten days.
More...

Thank you for the explanation.

So... when you look at quotes on options chains available on the 'Net and it shows IV @ 0.20, you can't actually consider that low (as in: at/below 0.2 is low, at/above 0.8 is high), you have to compare it to the RV (realized) in order to make that determination?

And if that is correct, you really couldn't even buy Calls/Puts as a weekend hedge unless you had options software to determine whether IV was high and had jacked up the premium?

morganpbrown · Sep 17, 2021

MrMuppet said:
To answer @morganpbrown 's original question I try to make a very dumbed down explanation. Many options veterans may jump on me for this but bare with me, ok?

So the most important thing for understanding options is the fact that you can REPLICATE the options payoff through trades in the underlying. Let's make a simple example:

Let's say a stock is at 100$, you are bullish and want to go long.
You buy 50 shares and install the rule that every time the stock moves 1$ you buy or sell shares in a decreasing manner as the stock moves away from 100$. For every 1$ move away from 100$ stock price you trade 1 less share. You start with buying 10 shares at 101$ and selling 10 shares at 99$, you buy 9 shares at 102$ and sell 9 shares at 98$ and so on.
You will do this over 30 days and then stop, no matter where the stock price is then.

Let's say you are right and the stock goes up to 102$, so your original position of 50 shares is now 69 and stock continues to rise. at 107$ you have 99 shares.

The number of shares you have is your delta and the difference between the current add and the next one is your gamma, which is one share (delta) per 1$ move. Voilà, you replicated a 100$ at the money call option with 30 days to expiration.

Stocks rarely go up in a straight line, and the problem that results from this is that your position is always the highest the more the stock moves in your favour, so you lose more, when the stock retraces.

Let's mix this up a bit.

You start at 100$ with 50 shares. Stock goes to 101, you add 10, it goes to 102$, you add 9 shares, it goes to 103$, you add 8 shares and now it retraces to 102$, where you will sell 8 shares.
The stock goes up to 103$, you add 8 shares again. Your position is 77 shares just like before the retracement, but you have lost 8sharesx1$ = 8$ on the way. The stock keeps on trucking to 107$ without any further retracements after that.

It will be intuitive that the more violently the stock moves back and forth during those 30days the more you will lose. When it goes from 100$ to 105$, back to 102$ before it goes to 106$, the losses you make due to the fact that you buy high and sell low will be higher comparet to a stock that goes from 100$ to 100.20$ to 100.10$ and back to 100.50$.

Still with me? Fine.
The losses you make during the stocks path to target are comparable to the premium you pay for an option.
In the first example we replicated a 30 day 100$ call option that had 8$ premium, as we lost 8$ on the way.

When the stock moves more violently aka is more volatile (or it's "average daily returns are higher"), you lose more, so you pay more premium and vice versa.

With that info fed into our brain, we can go ahead and talk more about volatility:

The examples I gave above generated returns through realized volatility. Thats the volatility the stock actually had during those 30 days. You can calculate it yourself in excel.

Back to options. Let's say the 30day100$ option for our stock in the first example costs 10$. Without crunching the numbers we know that the option is more expensive than our replication by trading shares.

So the option IMPLIES a higher volatility and if we replicated it via trading the stock and sold the option short, we would have made a 2$ profit.

Now to a more sophisticated explanation:

In order to compare nonlinear instruments, you need a common denominator. And some dude figured out, that you can take the options price, add the stock price, time to expiration, option strike to a formula that converts the options $ premium into a volatility figure...because that is the driver of all options premiums.

You cannot trade annualized interest rate of a 3m Short Sterling contract, but you use annualized interest rates to compare that 3m contract to a 10y treasury contract. It's just a math concept. So is implied volatility.

The BS formula is NOT a model that tells you how options should be priced according to the stocks historical volatility. That's how LTCM blew up.
Instead it is a mathematical framework that allows you to compare apples to apples aka compare a 60 day 20 delta option to a 10 day 50 delta option.

Options are driven by supply and demand and that ALWAYS comes first, NOT the volatility figure. You do NOT ask yourself why a 10d 5 delta option trades at 80 vols although realized 10d vol is at 20.

However you ask yourself how you can capture the 60 vols difference as a profit and at this point you speculate.

On the one hand you have a known return distribution which is implied by the options price, on the other hand you have an unknown return distribution which will be realized by how the stock moves during the next ten days.
More...

Fascinating and intuitive explanation. Many thanks for taking the time to share this.

BlueWaterSailor · Sep 17, 2021

MrMuppet said:
The BS formula is NOT a model that tells you how options should be priced according to the stocks historical volatility. That's how LTCM blew up.
Instead it is a mathematical framework that allows you to compare apples to apples aka compare a 60 day 20 delta option to a 10 day 50 delta option.

Options are driven by supply and demand and that ALWAYS comes first, NOT the volatility figure. You do NOT ask yourself why a 10d 5 delta option trades at 80 vols although realized 10d vol is at 20.

However you ask yourself how you can capture the 60 vols difference as a profit and at this point you speculate.

On the one hand you have a known return distribution which is implied by the options price, on the other hand you have an unknown return distribution which will be realized by how the stock moves during the next ten days.
More...

MrMuppet, you have a gift for teaching. And I say that as someone who's spent much of his life as a professional educator. As to it being "simplified", I've often told my students that I'm going to lie to them so they'll get the basics first and get curious about some things not sounding right later; when they start catching me out is when I'll know that I taught them well.

The point about LTCM, and about the general misunderstanding of where option pricing sits in the hierarchy of what actually happens vs. what the model says should happen is a very important one (it's certainly one of the misunderstandings I had about it early on, and it took me a bit to realize it.) But flipping it on its head - the price is what's true, the model implies that it should be something different, and regression to mean says that the price is likely to return to the predicted value - is a pretty good place to lay your bets.

(I've also seen vol described, from a practical perspective, as a steadier, slower changing descriptor than price. A bit less of a consideration these days vs. floor trading, but still makes sense when comparing two options - or the RV vs IV, as you just did above.)

SPX Options Trader · Sep 17, 2021

Too much education, textbook knowledge, and thinking, overthinking...can be a bad thing to your understanding and success.

Go out and trade those options in the real world, and get rich. and live happily ever after. have a fountain of money popping out your butts and mouths.

The markets, trading them, is part art, part science.
If you know too much...you become too complacent, and think too linearly. Much to your detriment.

I know what I'm talking about...because I make what you do in a month...in a day.

taowave · Sep 17, 2021

You are rapidly becoming my favorite poster

SPX Options Trader said:
Too much education, textbook knowledge, and thinking, overthinking...can be a bad thing to your understanding and success.

Go out and trade them in the real world, and get rich. and live happily ever after. have a fountain of money popping out your butts and mouths.
More...

destriero · Sep 17, 2021

SPX Options Trader said:
Too much education, textbook knowledge, and thinking, overthinking...can be a bad thing to your understanding and success.

Go out and trade those options in the real world, and get rich. and live happily ever after. have a fountain of money popping out your butts and mouths.

The markets, trading them, is part art, part science.
If you know too much...you become too complacent, and think too linearly. Much to your detriment.

I know what I'm talking about...because I make what you do in a month...in a day.
More...

Honestly, I think SSDI is your sole source of income.

SPX Options Trader · Sep 17, 2021

destriero said:
Honestly, I think SSDI is your sole source of income.
More...

I think you're thinking too much. Thinking too much like a square textbook...will get you nowhere in the marketplace.
But I don't want to turn this into a pissing contest.

BlueWaterSailor, did you catch anything in today's market, maybe a marlin, a giant octopus, a shoe,
taowave, did you surf a wave of profits today, or did you get wiped out,

destriero · Sep 17, 2021

SPX Options Trader said:
I think you're thinking too much. Thinking too much like a square textbook...will get you nowhere in the marketplace.
But I don't want to turn this into a pissing contest.
More...

Dude, you're woefully out of your depth. You're some serial banned nick who can't meet an account minimum.

Overnight · Sep 17, 2021

SPX Options Trader said:
I think you're thinking too much. Thinking too much like a square textbook...will get you nowhere in the marketplace...
More...

You never answered my original question to you. You have stated many times you are a simple buy put-and-call folk.

So how can I buy a simple call or put to help me in my current futures situation?

Since you mentioned you do not know anything about futures, I will make it easy for you. Assume they all expire on the 15th calendar day of the month they represent.

Anything?

destriero · Sep 17, 2021

Overnight said:
You never answered my original question to you. You have stated many times you are a simple buy put-and-call folk.

So how can I but a simple buy or put to help me in my current futures situation?

View attachment 268103

Since you mentioned you do not know anything about futures, I will make it easy for you. Assume they all expire on the 15th day of the month they represent.

Anything?
More...

Dude, you're addressing a monkey. The guy doesn't understand moneyness or intrinsic value. You think that he's going to respond to you about a synthetic call? C'mon. You may as well address the dude in Latin. Let it go and take a walk.