Tag Archives | implied volatility

Volatility and News

Although I am a believer in using options to hedge positions and reduce list, there is no doubt that there are many speculators who use options.

The purpose of today’s post is to warn those speculators about a dangerous trap — one that can be avoided.

News Pending

When a news release is pending, option volume increases because the news may result in a gap opening for the stock price (when the news is better or worse than expected). That is when option buyers make good money — assuming that they got the direction right.

However, there is much more to trading options under these circumstances than the novice trader can anticipate. That option volume pushes prices higher and you cannot pay whatever price is asked when buying options. At least you cannot do that and expect to succeed.

Read more about this scenario at my about.com site.

The discussion continues with a description of how implied volatility is crushed once the news is released. If you are not familiar with the concept that the price of options in the market place is very dependent on implied volatility, take a look here and here.

One method for significantly reducing the cost of playing this game is to trade call or put spreads instead of buying individual options.


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Implied Volatility and Beta


Isn't using IV (implied volatility) for statistics the same as using Beta as a measure of risk for stocks? I.e., if the stock dropped sharply and it's beta increases, but not the risk, it's actually a better price now. Same here – if the market declines today, does it really mean that tomorrow will be an even riskier day, as told by IV? If not it eliminates the need to trade fewer contracts on high IV times.



Beta and volatility are not comparable. Yes, in a broad sense you can say they measure a stock's volatility and tendency to undergo large moves. But the differences are very significant.

Beta MEASURES the PAST volatility of a single stock when compared with the volatility of a group of stocks.  IV is an ESTIMATE of FUTURE volatility for an individual stock (or group of stocks).

Beta is RELATIVE and depends on the volatility of it's comparative index (SPX or DAX) when we talk about volatility in the options world, it is an independent measure.  In other words, beta not only depends on the volatility of the individual stock, but it also depends on the volatility of the group.


Not the Risk

You said that the stock price declines, beta rises, and 'not the risk.'  Why do you believe that risk is less just because the stock is trading at a lower price? Okay, the total that can be lost is less because the sock price is nearer to zero.  So in that sense, risk is less.

However, risk is most often measured in terms of probability of losing money on the trade and not only in terms of dollars lost. Many traders believe a declining stock is more likely to decline further than reverse direction. That's the basis of technical analysis. Once support is broken, the bottom cannot be known. Trend followers jump on the bandwagon when stocks make big moves – in either direction.  I do NOT agree that the lower stock price suggests that owning the stock is less risky.

Remember Enron?  As the price declined, people bought the now 'less risky' stock – only to discover that risk had increased, not decreased.

There is a psychological rationale for buying stocks that fall.  Investors think about the fact that they were planning to buy at a price above the current level, so it must be a good, less risky purchase now.  Unless the stock has not broken support, there is no evidence that this is true.  There is always that feel good felling when you catch the bottom, but in my opinion, it's is too risky to make that attempt.


Getting back to beta

IV is an ESTIMATE of future volatility for an individual stocks or group of stocks.  Whereas implied volatility is very likely to increase as the market falls, there is no reason for beta to change unless it independently becomes more volatile than it used to be. Beta could decline if the individual stock moved less that its customary percentage of the index against which it is being measured.

When IV rises on a market decline, it is a fact that market participants believe that the market will be riskier tomorrow.  The evidence is clear and overwhelming. Traders pay higher prices for options – and those option prices are what determines the implied volatility.  Why do they pay those higher prices?  Because they are afraid that tomorrow will bring more downside.  They may be wrong, but that is the expectation. And IV is a measure of expectations.

Traders buy options when they want to insure a position.  They buy options when afraid.  They buy options when speculating.  Whatever the individual reason, the 'marketplace' buys options in anticipation of something bad happening.  That makes IV higher.

Remember when markets fall, they sometimes fall hard.  That's why people expect tomorrow to be riskier after a big decline. I see nothing wrong with that idea. Sure it's okay to fade the down move and sell a bunch of puts into a big decline.  You are getting a pumped price, but you are selling to the buyers who are far more afraid than you.  I have no reason to believe they are any smarter, but it does take courage to fade the crowd when selling into a falling market.  That's why there is a higher reward for option sellers who are willing to take the risk.

One reason for trading fewer contracts (as a premium seller) in a falling market is fear. The prices are attractive, we may be hoping that the decline will end, but there is that nagging fear of the huge bear taking hold of the marketplace.  I suspect it's not that higher IV per se that makes trades sell fewer options under such circumstances.


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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?



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.


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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.



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Iron Condors and the Greeks

Hello Mark.

1.  Last week I traded an iron condor on Apple (January and February expiration) at 350/360 on call side and 290/300 on put side.

Past Monday, the prices of all four options, January expiration, went up for no apparent reason!  My January positions started showing big losses.  February positions were fine for same company and same strike prices.  What happened?   

The implied volatility for January options increased.  You opened your positions when implied volatility was at its low point.  Because iron condors are positions with negative vega, they lose value when IV increases.  That's what happened to you.  If IV moves downward again, you will recover the losses quickly.  Otherwise, it's going to take the passage of time (without a concurrent stock move) to recover.

Today, both January and February iron condor went up in prices, and again I see big losses.  I thought time erosion and call spread would help me.  

There is more than one greek.  Each contributes to the value of an option independently of the others. 

Theta is your friend.  You earn a small amount each day.  However, that is being offset.  Gamma is the enemy.  If the stock moves too far, then you get short deltas quickly (on a rally) or get too long (on a decline). 

Vega is the culprit you right now.  Vega measures the dollars earned (or lost) every time the implied volatility moves higher or lower by one point.  Right now it is moving higher.

When the market falls and the put spread moves against you, the call spread will NOT decrease in value fast enough to compensate for the loss in the put spread.

It truly upsets me that you thought that selling a call spread for a smallish premium would ever be enough to completely offset the loss on the put side when the market declines.  Sure it helps, but never enough,  The IC strategy is not designed to have one winner to offset the loser.  It is designed to win when the market is not very volatile and doesn't move too far – as time passes. [And there is no need to wait until expiration to grab your profit]


Is it possible for me to calculate option prices, independently? 

Independently of what?  The market determines the prices.  The market determines whether you earn a profit or take a loss.  No you cannot calculate option PRICES independently.

What you can do is calculate a theoretical value for any option. You can make an estimate of where you think the options should be trading.  That calculation may give you the confidence to hold your trade, but it will be your opinion vs. the collected opinions of the rest of the world.

To make the calculations requires that you input an estimated future volatility for each option (that's all four of them) into an option calculator.  Not an easy task for anyone, let alone a rookie trader.  Estimating future volatility is very difficult.  Dare I say impossible for the vast majority?  It is better to allow the marketplace to generate the option values. Then you can make trades that you deem suitable.

You may not have planned it, but you decided it was a good idea to get short AAPL vega at the time you opening the iron condor position.

What happened to you and your trade is that you chose to own negative vega at a bad time.  Not much you can do about that now.

2. My broker, thinkorswim, does not charge commission if I buy back short options if they are worth 5 cents or less.  Is it a good idea to take this offer? 

Yes.  I approve of reducing risk whenever possible.  Paying 5 cents is cheap insurance.  If there is just one day to go prior to expiration, then that's different.  There is no urgency to pay the nickel at that time.  But I love to pay that price (and more) to exit. I am also happy to pay commissions to eliminate the risk.  Free commissions make it a no-brainer for me.

3.  How do I know where (in stock, equity or ETF) a pro like you invests in iron condor? 

You cannot know.  Nor should you care, except perhaps to see it as an example.

There is no 'best' premium to collect and there is no best strike price to sell.  Nor is there a best time to enter the trade – unless you are a strict adherent of technical analysis.

You (honestly, I am not making this up) want to own a position that makes you, comfortable.  If you try to guess which position makes someone else comfortable, how is that going to do you any good?  You would not know when that pro makes an adjustment or exits the trade.  You must find trades that please you.  Sure you can read about what I do, but there is no good reason for you to attempt to do the same. But think about this:  You have no idea whether I am struggling, doing ok, or making a ton.  Not am I going to tell you.  It is completely irrelevant.

4. [A later follow-up to the original e-mail conversation] I can see that options pricing is lot more complex than I imagined.  I thought that earlier I place trade for next month, I get better price.  But that is not true.

It is true as far as theta is concerned. However, there are other factors that influence the price of options.

Here is the bottom line for you:  You clearly jumped into trading a strategy with no clear understanding of how it works.  That's fine when trading in a paper-trading account, because that's one good place to learn all about the trades being made.  But when using real money it's just foolish to think you can trade now and learn later. 

I find it very sad that you are in this position.  What is your hurry?  You have the rest of your life to trade and now is the time for learning.



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Diagonal Backspreads

Hi Mark,

I have a question on ratio diagonal spreads that I was hoping you could answer for me.

The spread is as follows: Sell 1 ITM Option, Buy 2 OTM Options where the IV of the front month option is higher than the IV of the back month options (e.g. Sell 1 ITM Nov Call, Buy 2 OTM Dec Calls).

I noticed that the position will lose money if the IV of the Dec options (the ones I am buying) declines. What type of adjustments can be made to this position if the IV of the long options starts to decline?




The backspread is one strategy that I seldom discuss, primarily because it's not easy for individual investors to manage.

The diagonal backspread is a separate category and is worthy of a discussion. 

By definition, the backspread is an option position in which the trader owns more options than have been sold.  Thus, your 2:1 spread qualifies as a backspread.

Vega Risk

When owning options that expire later than the options sold, one unchangeable characteristic of the position is long vega.  Thus, the P/L picture is significantly affected by changes in the implied volatility (IV) of the options – between the time the position is opened and closing time [And that's true whether you exit voluntarily or hold through expiration].

The simplest method to guard against an IV decline is to sell vega.  And the simplest method for doing that destroys the very reason you opened the trade in the first place.  That method is to change the diagonal backspread into a 'regular' backspread.  For example:

a) Sell two Dec/Nov OTM calendar spreads.

This leaves you with the Nov back spread:
Long two Nov OTM; short one Nov ITM
It is not likely that you want to own this position

b) Sell one ITM calendar spread

This leaves you with the Dec back spread
Short one Dec ITM and long two Dec OTM

This idea is unsuitable.  Traders who use diagonal back spreads have a very different market outlook (expiration to arrive with the near term option's strike price being near the underlying price) than those who own  same-month backspreads (hoping for a very big move – so big that the ITM option is very far away from the price of the underlying).

It's nice when the simple method is viable, but in this case it is not.

A more complex solution is to add new positions with negative vega to your portfolio.  However, this requires trading several positions simultaneously, and not every trader wants to do that.



In my opinion, no single strategy is good enough to use all the time.  We must pick and choose our spots.  When IV, as measured by VIX, or better yet, the IV of your specific underlying, is relatively high – and you have no reason to anticipate that it will move higher – that is not a good time for owning positions that are vega rich.

I get it.  You still want to make the play that pays off when expiration finds the stock trading near the strike of your ITM short.  If you have a very strong predictive ability, and if you want to make that play, there are alternative strategies that have less vega risk.  (Butterfly for example).

However, if you predict market direction and future prices, then you should be willing to predict the IV direction as well.  There's no need to get it exactly right.  But, if you believe it's not going higher, I would avoid the diagonal backspread.  That spread is most appropriate when you have some reason to anticipate that IV will not be declining over the next few weeks.

I agree that this is something difficult to predict, but the diagonal backspread comes with vega risk.  You must deal with it or only accept that risk only when willing to do so.

If you insist on using this strategy because you had good results, consider trading smaller size when not confident about future IV direction, and larger size when confident it will incease. 

Another possibility is to divide your trade into two parts.  One is to use your diagonal, but in addition, perhaps you can sell a credit spread with strike prices that suit your prognostication.  That credit spread comes with negative vega.  It won't have as much vega as your diagonal backspread, but it is a hedge in that it partially offsets vega risk.

The bottom line is that it is easy to hedge delta risk, but vega is another matter.  The hedge is to sell vega, and that is difficult when owning diagonal backspreads.


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the Magic of Higher Call Prices for Falling Stocks


I still consider myself a rookie so I have what may be a
"rookie" type question.

I am selling covered calls and I am seeing that
the option/stock price relationship has NOT been maintained in a way
that I would expect. The AAPL stock price is lower, but the option price is still higher than when I sold it. (There
was a big run up in price before falling back to today's level.) There
hasn't been much passage in time as I bought/sold in April.

What would cause this? (I have to admit I don't understand the Greeks




Hi Larry,

This is a common problem and easily explained.  Once you get it, you will remember.  But, until you read or hear that explanation it can be a true puzzle.

An option's price is based on several factors, such as the stock price, strike price, time remaining.  But the crucial factor that determines how much the price of an option changes in the marketplace is volatility.  Each of these factors is plugged into a computer, which calculates the value of an option based on one of several models.  One of those models may be familiar to you: Black-Scholes.

Simply stated, if market participants believe the market (or sometimes the specific stock) is going to be volatile from right this minute through expiration day, then the options are worth more.  Buyers bid higher prices and sellers demand a higher premium for the risk they are accepting.

Why do they bid more?  If you buy an option, you want to see the stock move higher (calls) or lower (puts).  The larger the anticipated move, the greater the profit potential.  That translates into higher bids for those options.  Similarly for sellers, big moves turn into larger losses, so they demand higher prices to offset some or all of that risk.

That expectation for increased volatility (compared with the expectation when you wrote or sold that call) is the reason the option prices is higher.  And that option price can go higher still.  Or it can drop like a rock.  All depending on that expected volatility.

To keep it simple, a volatility estimate must be plugged into the Black-Scholes model to generate a theoretical value for the option.  the higher the volatility, he higher the option price.  If you have never played with an option calculator, you should do so.  It can open your eyes.

But that's the reason your call is priced higher today, even though the stock is lower and some time has passed.

Regarding the Greeks.  Do not be afraid of them.  the Greeks serve one purpose:  To measure risk of holding a specific position.  When the investor finds that risk to be unacceptable, action is taken.  You may exit or adjust the trade.  The point is that the Greeks give you a good estimate of how much you may make or lose if such and such market event occurs. 



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VIX Graph March 26, 2010

The stock market was more volatile this week, and VIX stopped it's current decline.  Whether this is merely a pause in the current downtrend, or signal that the lows in VIX have been seen, is anyone's guess.

The bulls remain in control of this market, but the bears are not in hibernation.  I can hear them growling.  Maybe it's just that noise than keeps option buyers in the marketplace.  Those buyers support option prices, and IV does not tumble.

Perhaps I'm grasping at straws in an effort to understand what's happening with VIX.  As the future unravels, we will learn more.




Lessons of a Lifetime:

My 33 Years as an Option Trader 

by Mark D Wolfinger

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