Tag Archives | vega

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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As expiration nears, how does theta behave?


I am currently on my second round reviewing the greeks, and this time I am going into more depth. As I am putting together my notes I found references that describe time decay for both OTM and ATM positions. To my surprise, the shape of the graphs is different.

The graph that we are all accustomed to seeing shows that time decay accelerates as expiration nears. Most of the theta decay occurs in the last 30 days in which theta is increasing as the remaining time value of the option is decreasing.


When it comes to OTM options, according to the authors, the shape changes significantly. In the last 30 days, decay decelerates and the majority of the decay occurs before the last 30 days. This is the graph of an OTM option and its time decay.


I have been looking at various option series for both stocks and ETFs and I have not been able to confirm this.


If the above statement is true, when trading iron condors, why wouldn't you pick a timeframe for opening the position near 60 days to expiration and probably closing ~30 days before expiration? This would allow the trader to capture a larger portion of the time decay – because OTM positions make up the iron condor.



This is a very thoughtful question and illustrates why spending time trying to understand the things we are taught is such a good idea.  Thank you.

The general view regarding time decay is correct.  Theta accelerates as expiration approaches.  However, we must recognize that some siturations are different.  Let's say that a stock is trading near 79, there's a week left prior to expiration, and the option under consideration is the 80 call.  Surely that option has time value and with that comes time decay – and the option loses value every day.  Just as you anticipate.

However, consider the call option with a 50 strike.  Unless this stock trades with an extreme volatility, the call has already lost all time value (except for a component due to interest rates) and trades with a bid that is below parity. 

Or you can look at the corresponding put (which has the same theta) and see that it doesn't trade and the bid is zero. It has already lost every penny of it's time value.  Its theta is zero.

These are the situations to which your references are referring when stating that time decay decellerates into expiration.  When options move to zero delta and 100 delta, the time decays disappears prior to expiration.

Most traders who are talking about options and their time decay, are not interested in such options (there is nothing of interest for a trader to discuss).  Thus, options such s the 80 call mentioned above (and the corresponding 80 put) have time value, accelerating time decay and an increasing positive gamma.  These options decay according to your first, or 'standard' graph.

FOTM options

There is more to the rate of time decay than the time remaining.  When options are far OTM or deep ITM, things are just different.  Once you understand that situation (as I'm certain you do now), the theta problem goes away. Once an option has only a small time premium remaining, it cannot keep losing value at the same rate – or else it would become worth less than zero.

Iron Condors

Time decay is what makes trading iron condors profitable. Sure it may be good to own the position when time decay is most rapid, but that is not the 60 to 30-day iron condors that you envision.  That would work only when the calls and puts are both quite far OTM.  That means a tiny premium to start the trade.  That's a non-starter for me.

In the real world of condor trading, most options are not that far OTM and have enough time premium to belong in the standard decay group.  When markets behave for premium sellers, the last 30 days are the periods with the most rapid time decay.  For most iron condor traders, that is the ideal situation. However, that's also the period of highest risk – due to negative gamma.  For me, collecting the fastest time decay is not as important as owning a less risky trade.



Peace on Earth.  Liberty for all.  Best wishes for 2011



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Gamma, Vega and Risk Management

When trading options, holding positions with too much gamma – positive or negative – can be dangerous. It's necessary to avoid getting hurt by the two most destructive emotions for traders: fear and greed.

On Monday, Jun 28, 2010 the markets fell hard.  That 1040 SPX price level – that many believe is a vital support area – was tested.  Option prices rose sharply as is seen in the performance of VIX and RVX.

Tuesday (as I write this) the markets are slightly higher and option prices are once more coming down to earth.  I had better rephrase that.  Option prices and implied volatility are decreasing, giving up a significant portion of yesterday's gains.  In my opinion, prices are still high.  ADDENDUM: By the end of the day, the markets closed lower.  SPX broke down by trading below 1030.

When IV moves sharply higher, the trader who is not vega neutral, and that includes most of us, must demonstrate the ability to handle and manage risk.  If you are a clear thinker and make good trading decisions, your portfolio is probably in good shape.  The same can be said for most traders who prepared a trading plan in advance.  That plan is designed to save any trader (and especially the inexperienced) from panicking in a stressful situation.

Positive gamma and vega

As the markets get more volatile, and especially as markets decline, traders who own positive gamma and positive vega are well positioned to profit.  Nevertheless, that trader cannot afford to idly watch the markets as the days pass and theta takes its toll. 

Positive gamma is a delight in that it allows the trader to pick the time and place for making an adjustment.  This adjustment locks in profits and can include the sale of some options to reduce both gamma and vega, or it can be made in the form of shares of the underlying (stock or futures contracts).  It's tempting to hold the position, but a minor reversal, such as seen Tuesday morning threatens much of the profits.  Greed makes the trader hold out for larger gains.  Fear makes the trader panic and sell (what is probably) an inappropriate portion of the position.

However, a well-thought out plan, or sound risk management, allows the trader to reduce risk by moving closer to neutral in gamma, vega, and delta.  Ignoring greed, the successful trader adjusts the position – retaining some vega and gamma.

Negative gamma and vega

Iron condor traders seldom find themselves in the positive gamma/vega boat.  The only exception occurs when extra options are owned as insurance, and these extra options are in play (not too far away from being ATM).

Thus, they (we) may be floundering when the positive gamma group is sailing along smoothly in those choppy waters.

If your positions have too much negative gamma, if your short options are not too far OTM, then it's time (or past time for many conservative traders) to adjust the position.  Panicking in a sudden meltdown is unlike to produce good results.  However, ignoring problems, hoping they will disappear, represents a different type of panic decision – being too afraid to act.

If you have a trade plan in place, it's probably right to take the action as prescribed in the plan.  Lacking a plan, it's not too late to create one now.  If you are capable of making sound decisions as losses mount, then good for you.  Take advantage of that skill by taking sound steps to protect your assets.  Be aware of potential loss, your pain threshold and comfort zone boundaries.

If you lock in a loss and the market reverses, so be it.  Your goal is to pay attention to rule #1: Don't go broke.

If you are not yet in trouble on this decline, you have the luxury to plan ahead.  I'm planning to sell extra vega by doing a ratio roll down* for some RUT Aug and/or September put spreads.

* Close current short put spread and sell a larger quantity – perhaps 3 for every 2 bought – of farther OTM put spreads.  I prefer to move the strike of the short option by at least 3 strikes.  Collect a small cash credit for the trade.  I only do this when my portfolio is not already at its maximum size.  Make no mistake about this trade: it does increase ultimate risk.  it looks good because the probability of the large loss is reduced.

Example buy two 560/550 put spreads and sell three 500/510 (or perhaps 510/520) put spreads.


Kindle book available:

Lessons of a Lifetime: My 33 Years as an Option Trader;  $10


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How Much do I Lose on a 5% Market Decline?

Here's a very simple question from a reader.  And to be honest it's an excellent question and it's something I have never specifically addressed.  I've told readers to do it, but without details.


Just read your post and would like your help on how to most accurately determine how much a portfolio will lose from say a 5% fall?

Underlying:  RUT. 

Here are the Greeks: -50 delta, -5 gamma, +300 Theta, -800 vega.
Thanks for your help,



That's a lot of vega!  You did not supply enough information, so I'll make assumptions.  I need the current IV (so we can estimate the new IV, post decline).  I'll use RVX, which is near 35.

Most accurately?  That's a tough one.  You must have a very good estimate of how much IV is going to increase, especially when your vega risk is substantial.  That is difficult all by itself.

A) I would use software – hopefully provided by your broker – that plots positions on a graph.  Look at the position with RUT down 32 points to 614.  Then increase IV by ?? Try 10 and 20% as guesses. Change the date to one day later.

If such software is unavailable to you – consider opening an account at TOS.  No need to fund it.  That should allow you to use their excellent software.

B) Lacking good software, then your next best answer is to break down your position into it's individual option components.  I understand that you may have so many different option series that this is going to be too time consuming.  However, if you own just one or two different positions, then it's probably worth the time to do it.  Find an options calculator.

For each single option in your portfolio, determine the option's value at today's price and tomorrow's price.  For tomorrow's price, use the 5% decline number and once again make a guess as to the future IV.  There is no way around that.  We don't know of there will be panic or relative calm in the marketplace.

Multiply each option by the quantity in your portfolio and determine how much is lost.  It's a good idea to record the new Greeks to help make a similar estimate in the future.  By that I mean it's good to know how gamma, vega change and theta change.

C) If you are willing to accept a less accurate method, then we have to do a 'quick and dirty' calculation – and that's the basis for this post.

1) Gamma.  We don't know the rate at which gamma changes, so let's guess. Gamma is now -5 and will be -10 after the 5% decline.  I admit this is just a guess.  Thus, we have a 32 point decline with an average gamma of -7.5.

2) Delta is -50 and will (negatively) increase by 32 * 7.5.  New delta: -290.

Average delta over the decline: -170 (avg 50 and 290).

32 * 170 = $5,440.   This is the loss from delta

3) Theta.  You get your $300, but theta is almost certain to be higher tomorrow.

4) Vega.  Assuming vega remains near 800, and assuming that IV increases by 10%.  That's an increase of 3.5 points or a loss of 3.5 * 800 = $2,800

Simon, please remember that each of these Greeks is changing.  Just as gamma changes delta, so to do gamma and vega and theta change as the underlying price changes.  Thus,these are merely good guesses.  They work as a ballpark figure.  they allow you to decide whether this risk is too large for you to accept.

Here's where it gets tricky. 

a) The problem is that if panic were to set in, then IV could double to 70.  If that happened, the estimated loss – just from vega alone – would be $800 * 35, or $28,000.  If you were to incur that loss – and if you did not have an margin call and were allowed to continue to hold the position – the question is would you do so.

NOTE: If using Reg T margin and if your positions are protected (i.e., no naked short options), then you will not get a margin call.

b) There is a limit to possible losses.  If you own (for example) 20 iron condors, then it's impossible for the loss to exceed $20,000 minus today's position value.  And I'm sure you understand it would never get that high. 

If the markets were very wide, then your position could get 'strange' closing marks, but I do not believe it's possible for your account to be placed in jeopardy.  But this is a question for your broker, not for me. [What happens if my 10-point iron condor is market a 15 points?  Could I be forced to liquidate?]

Markets can be very wide, but when options are being quoted, the is every reason to believe that it will be impossible to collect >$10 for a 10-point iron condor and I assume that means your end-of-day marks must be in the rational range.  Thus, I assume liquidation is something we can all safely ignore.  But, it is an assumption.

c) If the market does drop that far and if IV does rise that much, I cannot imagine that your loss to vega could be that high.  It fact, at that level, your portfolio could easily be short far less vega.  In fact, when your LONG options are closer to being ATM that the shorts, you will be positive vega.  So the vega estimate is fraught with potential inaccuracies.  That's why the risk graph works so much better than anything else – for your needs.


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