Implied Volatility and Standard Deviation

Hi Mark, I have a few questions i hope you can answer.

1. Isn't holding a naked long call (as a result of locking in a profit or plain buying outright call) in general a bad idea? Reason I think so is because of the nature of IV: it mostly falls when the underlying is rising. So you have short theta and a big long vega moving against you.

And holding a naked put seems logical and natural.

2. Can IV be really considered as a Standard Deviation for a stock price? Same reasons to ask – why would a stock probability to be at a certain price range shrink just because the market moved higher? Why would it widen in case of a fall?

D.

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1.You are correct.  A rising stock price usually means that IV is falling.  Thus, any gains resulting from positive delta are diminished by losses from declining vega. Most novice call buyers miss that point.

You believe that it feels 'natural' to be short the put option and collect time decay. I also prefer to be short options (as a spread, never a naked option) because of time decay. However, I don't see anything 'natural' about being exposed to huge losses by selling naked options.  There is  nothing natural about that. [In further correspondence, you admit to having a big appetite for risk – and under those circumstances, selling options would feel natural].  Hedging that risk feels more natural to me – and that means we can each participate in the options world, trading in a way that feels comfortable.

However, the majority of individual investors – especially rookies – find that owning long calls feels natural: Limited losses and large gains are possible. That combination appeals to those who don't understand how difficult it is to make money consistently when buying options.  The chances of winning are not good when the stock must not only move your way, but must do so quickly. 

More experienced traders believe it makes sense to sell option premium, rather than own it.  Please understand: that is not a blanket statement.  There are many good reasons (hedging risk is primary) for owning options, but in my opinion, speculating on market direction is not one of them.

The problem with holding a naked (short) put option is that profit potential is limited and potential losses can be very large.  In addition, when the stock falls and you are losing money because of delta – IV is increasing and the negative vega is going to increase those losses. Although positive theta helps reduce losses – the effects of theta are often less than those from vega and delta.

Even though long calls and short puts are both bullish plays, they really serve different purposes.  Traders who want to own calls are playing for a significant move higher, while put sellers can be happy if the stock doesn't fall.  Put sellers have a much greater chance to earn a profit, but that profit is limited.  Selling puts is not for the trader who is looking for a big move or who wants to own insurance that protects a portfolio.

2. Standard deviation is a number calculated from data – and one of the pieces of data required is an estimate of the future volatility of the stock.

Yes, it appears that a rising market results in a smaller value for the standard deviation move, but in reality, SD decreases because the marketplace (and that is the summary of the opinions of all participants – the people who determine option prices) estimates (as determined by the prices and IV of options) that future volatility will be less than it is now.  You are not forced to accept that.  You may use any volatility number that suits to calculate a standard deviation move.

If you argue that it doesn't make sense for a mathematical calculation to depend on human emotions and decisions, I cannot disagree.  However, to calculate a standard deviation, it just makes sense to use the best available estimate for future volatility. Most traders accept current IV as that 'best' estimate.  That does not make it the best, it's just a consensus opinion.

If you prefer to use your own estimate to calculate a one standard deviation move, you can do that – as long as you have some reason to believe that your estimate is reasonable.

879

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11 Responses to Implied Volatility and Standard Deviation

  1. Dimitris 01/20/2011 at 6:02 AM #

    Mark,
    Looking for new ways to increase my retirement income (most of it comes from dividends) I discovered the following situation. Please help me understand what I am missing, because it seems too good to be true.
    One of the stocks I own is INTC. The current annual dividend is $0.63 and the stock price $21.01. If I want to invest $10000, I could buy 476 shares and receive an annual dividend income of $300.
    But, with less cost ($9698) I could trade a CC : sell #13 INTC Jan2013 7.5Call/buy 1300 shares @7.46. This means, I can own 1300 shares and receive dividend income $819 per year instead of $300!!!
    So, after two years, when the Call expires, I have to sell my shares @7.50 (I assume the stock price will be higher than 7.5. If it is less than 7.5, no problem, I will keep the shares) without any profit but in the meantime I have received dividend income much higher than in the normal (just buying the stock) situation.
    My guess is that, probably, it will be difficult to make this trade and even if I make it, I will lose my shares in the next ex-dividend date because the time value is zero.
    Thank you

  2. Dmitry 01/20/2011 at 7:13 AM #

    Thanks again for answering, but i was talking about long puts in the 1 question, sorry for didnt make myself clear.
    As for the deviations, i now see that option traders look at deltas as a probability. Earlier i thought that the width of the opening IC was based on standart deviations.

  3. Mark Wolfinger 01/20/2011 at 9:17 AM #

    Dimitris,
    I love questions from beginners. I love helping them find the ‘aha moment’ that opens their eyes to something they have not previously understood.
    The problem is that some traders prefer to look for obscure ways to earn money – ways that have not yet been discovered by anyone else. It doesn’t happen that way.
    It would be far better if you tried to understand more about options.
    However, in this case, your instincts are correct – except for one point. This trade will be very easy to make. If you make it, the trader on the other side earns free money.
    Not only does this option have zero time premium, but the bid is less than parity. That means you would buy shares (current quotes) @ $20.85 and sell the Jan 13 7.5 calls @ $13.30 or perhaps $13.35. That means you would collect that $13.30 now and then $7.50 when assigned. Note that the total ($20.80) is LESS than the price you pay for the stock. If you are smart enough to demand a price above parity, no one will trade with you.
    Now ask yourself what the market maker who makes this trade is going to do with the LEAPS options he bought. He is going to exercise prior to the first ex-dividend date. He then locks in his tiny profit (he paid $20.80 and sold shares at $20.85), he does not lose the dividend and he has no position and no risk.
    If he can earn more in interest by being short the stock than he can collect from the dividend (this is not likely in today’s world), then he will pay the dividend and collect the interest. He wins in either situation. But, the interest play is not available, and your result would be a loss.
    Note the open interest is zero and these options have probably not yet traded.

  4. Mark Wolfinger 01/20/2011 at 9:20 AM #

    D,
    The term ‘naked’ can refer to long, but in general, when the adjective (long or short) is not used, ‘naked puts’ are considered to be ‘naked short puts.’
    The reason is that ‘naked’ describes risk. There is no ‘special’ risk associated with being long options. Thus the ‘naked’ part is associated with being short.
    Some traders do open IC based on standard deviations. Some open them based on delta (probability of finishing in the money) of the short options. Others on the cash premium collected. There is no ‘standard’ method.
    Regards

  5. Roberto 01/20/2011 at 9:46 AM #

    Hi Mark,
    about your last reply, I would like to know how to correctly calculate (and use) the “probability on profit” tool…
    Everywhere I look amongst the options sellers i read about it, and, behind the obvious, I think it may be an useful tool, but only if correctly understood (and used).
    Do you calculate it by yourself? Do you trust any site in particular?
    Thanks, as always
    Roberto

  6. Mark Wolfinger 01/20/2011 at 10:09 AM #

    Hi Roberto,
    ‘Probability of profit’ is not something I calculate. Too many variables are involved.
    However, other items can be calculated – and those are probably what you want to know.
    I’ll post a more complete reply Monday. Sorry for the delay.

  7. Roberto 01/20/2011 at 10:25 AM #

    Thanks, appreciated.

  8. sandeep 01/20/2011 at 7:22 PM #

    Mark,
    As it is earnings season I would like to understand a little mare about reports I see about the “market makers expected move” of a stock after they report earnings. For educational purposes I am looking at BAC that reports tomorrow morning. The stock price is now about $14.50. The 15 call is about $0.10, and the 14 put is about $0.10. Thus, a person betting on a big move up or down after earnings would pay $0.20 and have break evens of $13.80 and $15.20.
    Would it then be correct to say that the market is predicting that the move will be within a range of +/- 70 cents after earnings, and that the market is anticipating a move of up to 4.8% (70/1450)? ? Thanks.

  9. Mark Wolfinger 01/20/2011 at 9:16 PM #

    Hello s,
    Remember these options expire tomorrow (it’s Thursday night), so the stock price must change, or they become worthless.
    The market is not predicting that the move will be within +/- 70 cents. It is attaching a probability to a move of < 70 cents. It is attaching a probability to a move of > 70 cents.
    Thus, the ‘prediction’ is never wrong, because it is not a prediction. It is a probability. Many journalists and bloggers get this wrong by stating that the option prices predicted something.
    It is correct to say (this specific example should be obvious to you because the options are so cheap. It gets more complex with higher priced options) that the expectation is that these two options will remain out of he money once the news is announced.
    If the probability of a larger move were considered to be ‘much more than zero’ – then the options would cost a lot more than $10 per contract.

  10. Dmitry 01/21/2011 at 2:43 AM #

    One more question, Mark:
    Is it a viable strategy to hedge the IC vega with longing any volatility instrument (VIX RVX etc.)?
    The way i see IC risks are more “risky” on the downside because of increased IV, so i am now shorting 20 delta on RUT Mar calls and ~17 on puts. Im also long VIX Feb vertical (despite it being futures-based).
    Im abit concerned not having a black-swan insurance.. just abit, buying 1 RUT straddle/strangle look to expensive for an insurance. So can the VIX vertical be viewed as a bottom-side black-swan hedge? Thanks.

  11. Mark Wolfinger 01/21/2011 at 9:16 AM #

    Dmitry,
    Yes. It’s viable. But it’s important to trade the correct volatility product and be certain the hedge is also viable.
    There are better products to trade than VIX options.
    Please see this reply to Al for more details and suggestions.
    Trading iron condors with short delta is fine. You are near neutral and those few delta work because it adds to your comfortableness with the position.
    All vertical spreads have limited profitability. Thus, they can never earn enough money to provide true black swan protection. I agree that RUT strangles are costly. The best insurance is going to be the most expensive and the real decision is just how badly do you want to own that insurance and how much are you willing to pay.
    I confess that I do not own any right now, but my portfolio is smaller than usual and that provides some safety.