Implied Volatility: Why does it change?

I recently received the following e-mail question It's fairly simple, but on further analysis I find it most disturbing:

Is it possible to find out who changed IV and why and for how long?

Here's the background: Last week I posted a discussion based on a readers question about an iron condor position that immediately lost money (it's worth reading as background for today's post).  Because he expected to collect theta every day – especially when the underlying asset did not undergo a large move.  Basically, he didn't understand how this loss could have happened. The question above is the result of my telling him that the implied volatility of the options had increased.

In other words, he was trading iron condors as if they were money in the bank. An increase in IV took him by surprise, prompting today's questions:  Who is responsible for the higher IV?  Why was it changed?  How long will it last?

Every question deserves an answer, especially when an explanation may turn into an 'aha moment' for the questioner.  What truly disturbs me about this innocent-looking question is that it demonstrates a complete lack of understanding of how the markets work.

When playing a game or when practicing some trade ideas with play money, there is no question that's out of line.  There are two types of trader who use paper-money accounts:

  • The beginner who is trying to gain an understanding of how to trade and what has to be learned
  • The expert who is fine-tuning strategies, looking for any additional small edge

The beginner is expected to be learning as he/she goes.  Reading, taking classes, attending webinars – and asking questions.  I'oveheard very unsophisticated questions – and that's to be expected.  But the questioners learn from the answers and move beyond the basics.

Today's question comes from someone who is using real money (although I don't know the size of his positions).  This single set of question tells me that he is not yet ready to trade.  The whole concept of options trading, options markets, how prices are determined and what options are worth has not yet been grasped.  There's nothing wrong with that when using play money.

It's fun to win and there's no harm done whe losing money.  Asthe trader plays, he/she gains playing experience, and insight into some subtle strategies tha had not yet considered, etc.  That's how one becomes a better player at chess, monopoly, backgammon, or any other game.  As long as you are not playing for money and the game is taken seriously by the participants, it's a good learning experience for everyone.

However, when trading with real moneyy, some elements of the game change.  There is the possibility of earning some serious cash, and that's fantastic.  There is also the chance of losing far more than the player realizes is at stake, and that can be devastating.  Trading is not a game and one must have some basic understanding of the rules of engagement – and in this case, it's a basic idea of how the markets work.

In the previous post, I explained that his trade is losing money because his negative vega position is being hurt by a rise in the implied volatility of the options in his position.

 

Who changed IV?  Why?

No one individual changed the implied volatility of AAPL options.  Many thousands of contracts trade every day, and if anyone tried to bid prices higher or offer them at steadily lower prices, that person would be stampeded by everyone else in the marketplace who thought he was wrong-headed in his efforts.

It takes much more than a single 'who' to 'change IV. Changes occur for basic reasons, and subtle factors make a difference. 

  • Supply and demand is often 'blamed' for IV changes.  Look at it this way.  If option buyers – and that means calls and/or puts – far outnumber sellers, then sellers must demand a higher price – even when the stock has not moved.  If buying continues, prices move higher again.  This is normal market behavior, no matter what product is being traded
  • Market maker positions:  When they sell options to the buyers, their primary job is to reduce risk.  They must buy other options, preferably on the same underlying

It's true that most of today's traders use computers to generate orders to buy/sell options in different underlying assets.  However, after selling to public or institutional buyers, the market makers preferable next move is to buy, rather than sell more options. So they raise their bids and offers.  To do that, they raise the estimated future volatility estimate built into their trading algorithm. This is not a conspiracy.  Each trader independently raises or lowers bid according to his/her need to own/sell vega, gamma, theta delta, etc.

Those algorithms tell their quote-generating computers to raise or lower the trader's bid/ask quote

It's true that different market makers make different quotes, but when there is more demand for the  options, then prices move higher

  • Fear/complacency.  When 'people' [individual investors, market makers, speculators, hedge funds etc.] are afraid that the market may do something drastic, or when they fear that their portfolios are not well-hedged against potential losses, they buy options as insurance.  It doesn't matter whether they buy puts or calls [Remember that puts are calls and calls are puts], the purchase of any option can drive prices higher – when there are enough buyers.

We have all seen SPX volatility (as measured by VIX) decline from over 80 to 15 over the past two years.  And even traders who have not been in the market that long have seen IV decline over recent times.  They've seen it, but do they understand why this has happened?  Today's questioner apparently has not given it a moment's thought.  It happened because the markets have been dead.  Extreme low volatility begets option sellers.  But, at some point, sellers become buyers.

I don't know if the decline in IV is ended, or if the current increase is just a bump in the road.  I do know that someone traded an iron condor without any understanding of what could happen to his position – other he would collect time decay.

 

For How long?

Another impossible question.  Until there are enough option sellers to satisfy the buyers without prices moving higher.

I  truly hope this gives you a more clear understanding of the markets.  They are very complex and not easily understood.  I guarantee this: Neither you nor I will ever understand them well enough to be able to just print money.  Trading is difficult work and it takes training and education and skill to succeed.  The sad fact is that some people have no chance.

If you take the time to understand how each trade makes or loses money, what must occur for that profit or loss to be realized, and if you can discover how to estimate the probability that such events will occur,  then you are ready to trade options.

If you open positions based on theta alone, you will not be one of the success stories.  You have work to do.  Good luck and good trading.

871

TylersTrading

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5 Responses to Implied Volatility: Why does it change?

  1. Ann 01/10/2011 at 1:49 PM #

    Mark, I’ve been buying options for a while and found that it’s better for me to set stop losses based on lows/highs of previous days or some tech level rather than a flat percentage or point stop of the option premium. Get stopped out too often this way.
    However, I like to know ahead of time about how much the option price might be down if this technical stop is hit. I used to set my stops at a flat 25% from purchase and like the idea of limiting losses to 25% if possible but in conjunction with setting the stop based on the price/technical factor.
    Based on this I’ve been trying to determine which ITM option to purchase in order to line up my technical stop with an approximate 25% loss if hit.
    I know there are a variety of factors with this and no way to nail this but just trying to get close all things being equal.
    Is there a way/calculator/software that can help with this or does one just have to try and calculate manually?

  2. Mark Wolfinger 01/10/2011 at 3:06 PM #

    Ann,
    I don’t see an alternative to manually, but perhaps someone else will suggest just the right calculator.
    1) I’m not an option buyer, but I absolutely agree with your preference for using stops with options.
    Option premiums can get crushed for reasons that have nothing to do with your reasons for buying them, and an IV decrease is no reason to exit the trade.
    2) A typical option calculator can help – but nothing (that I know) will give you exactly what you need.
    Try this: Remember: you will need an estimated date to calculate the option price
    a) From option value, calculate current implied volatility (IV).
    For stock price, use stop price from your technical work.
    Choose a future date. It may be an arbitrary ‘one week’ (or other). Or it could be your best guess as to how long it will take to achieve your profit objective.
    b) Use that IV, stop price, future date and option value (75% of cost) in calculations below:
    When you set three variables, you can determine the fourth.
    Thus, best guess is to: use IV, stop price, option price. If date (to be calculated) is feasible as a holding period, then this option gives you the 25% loss at the stop price, on that date.
    Vary dates or option choice. This is trial and error. But, after a few times, you will discover shortcuts.
    Does this make sense – i.e., is it feasible for you?
    Regards

  3. Ann 01/10/2011 at 3:13 PM #

    Makes sense. Ive never used an option calculator. Any you would suggest? Does CBOE website have a decent one? Just needing a ballpark so this could help. Thanks

  4. Mark Wolfinger 01/10/2011 at 3:17 PM #

    Ann,
    Yes, through iVolatility.com
    Link

  5. Implied volatility 03/14/2011 at 2:52 AM #

    Nice post!
    Consumer would often feared when the implied volatility are goes up because then market prices are goes down. You are so good in your niches. Hope to see some more like these.