Q & A – Implied Volatility in Options Part 8
Q & A – Implied Volatility in Options (Part 8)
(Q) Special Doctor is asking how can you see if the price of an option is too expensive?
Um, well, let’s see. So, what I would do is I would be comparing today’s level of implied volatility to past levels of implied volatility. If today’s level is higher, than I would consider it expensive, but I think one of the things I said earlier, it’s not necessarily a situation where you automatically sell. You then have to further evaluate and ask yourself, why is today’s implied volatility higher than previously? And of course, right In the middle of earning season, if you were doing that over the past week or two you would see really juicy option premiums out there for good reason. The stocks might move tremendously more than they normally do after earnings announcements. So, you have those expensive options, but if you sold them you may have gotten killed because of huge stock move. Some of these earnings moves have been massive. So expensive is one thing, selling opportunity is another, but the way to really compare option prices to one another and determine expensive or cheap, or I should say inexpensive is to compare current levels of implied volatility to past levels of implied volatility. No real easy way to do that other than gathering data keeping data or tracking on your own, where implied volatilities are one day to the next and then getting a feel for it. That’s the way we had to do it when we were trading volatility professionally.
(Q) Julio wants to know is it a good idea to go long on a straddle and then when IV dies, you sell one leg and hold onto the losing leg until it breaks even? Let me see. So you buy a straddle and then I think it said when volatility gets crushed? Correct, when IV dies or when volatility dies, do you sell one leg and hold onto the losing leg until it breaks even?
Well, I think maybe that is assuming one leg is profitable at least has value. So, you bought a straddle stock moves a little bit and you sell off one leg. Well, it’s hard to really to say because I think every situation is going to be a little different. If you buy a straddle, say the hundred strikes straddle, and earnings comes on its kind of a dud and volatility gets crushed. But the stock moves down say 98. You’re still underwater, you know. Are you going to sell the put for two bucks and hope the call becomes worth something, or you just ride that put down and you know. There’s really three things you can do. Sell the put for two and hope the stock retreats the other way and I’d say that’s probably the least likely thing to happen. Your other choices are take your two bucks and take a loss on the trade mitigate your losses and get out. I’d say it’s probably the most common, and then in between there would be just ride the put and then see if you can get more than two bucks for it since the stocks already moved that way. You know, it’s really hard for me to say what the right way is to do it because I really think in these types of questions in general and should I do this or that when I manage the position. I always end up answering it as you know, would I make a different decision every time because every circumstance is different. It’s hard for me to be specific on that.
(Q) Judy wants to know how soon does IV reset for long LEAP calls post earnings or post a binary event. Is there any time frame for the IV to return to normal?
Well, first of all, when you go out very far, you’re going to have a greatly mitigated effect on options. So that’s the question I think we’ll reference LEAPS. So, look at a leaps option in earnings season today. If you’re looking at an option today and you’re looking at a LEAP option expiring say next January, you know over a year out. There’s really not going to be much of any effect before or after, because think about it. That option has for earnings announcements priced into it. Yeah, one of them came off the board. So, you may see a little bit of a change there, but I wouldn’t think it’d be too noticeable. How often do they reset really? Almost immediately, but I do have to sort of say that assuming that the stock has made its move and it’s done with its move. You know, if the stock is really and I’m kind of saying that cause it’s fresh in my mind seeing some of these moves that we’ve had. If you have a huge move lower after earnings, that move may cause the next week or two weeks or month to be very volatile in that stock as people are trading in and out there. They are cautious, they are doubling up, they’re bailing out, all sorts of stuff is going on. So, I would say if the stock doesn’t move a whole lot in the earnings announcements, kind of out there if the move is done and everyone’s comfortable with it. That learning is in the near-term expirations that the volatility I should say in the near terms is going to reset right away. But if the stock is moving in a big direction one way or the other after earnings, of course, it’s going to take a while for that stock to settle down. You know again, kind of a vague answer but the stock move is going to dictate somewhat the timing on when the implied volatility will settle. And again, those long-term options should have a very muted effect because it’s not just one earnings announcements they’re worried about, it’s a series of them. So, you shouldn’t notice much there.
(Q) Chrome Dream wants to know is it wrong to think of Gamma as the IV of the option pricing itself, or is that not the idea measuring the rate of change of Delta?
Okay, let me let me think about that one. So is it wrong to think of Gamma as the IV of the option pricing itself or is that not the idea of measuring the rate of change of Delta? Right, I’d say the ladder of that. You know Gamma is really the driving force behind the option price with respect to stock price movements. And Gamma is arguably, and in my opinion, the most important Greek that large position managers have taken account because they’re concerned with. What if the stock moves up? What’s my position look like if the stock moves down? What does it look like? And it really is separate from that, and it’s your volatility analysis. So, you have Gamma attaching itself to Delta and Delta is only dependent on stock price movements. It’s really a separate idea that implied volatilities go up or down or get crushed after earnings and then your Vega, your other Greek entirely, is what you use to analyze that as a trader. You know thinking about my days on the floor, Gamma was always forefront to me. That was the one that I looked at and we can get into a really long discussion here. But Gamma implies things about your other positions. If you’re long Gamma, you’re going to be losing, or you have negative Theta, you’ll have positive Theta because it means you’re long option. So, they’re tied together in some respect that your Gamma tells you what your Vega position is. But as far as the movement of the option price; Gamma’s attached to Delta, Delta is attached to stock price movement and implied volatility is attached to Vega. I’d say it’s more of the latter that they’re separate issues.
(Q) What is the advantage of playing options on the day of expiry or perhaps a few days before expiration?
I think that question is probably looking at long options. buying them one or two days before expiration. I’ll just answer it from either direction. You know, I’ve done both probably more on the sell side than the long side, but buying options at that really, really short time frame. You know, a couple of things the options going to be cheap and your decay is going to be really fast. So if you’re looking to spend a little bit of money, maybe hit a home run on a big percentage gain from a one or two-day move, those cheap weekly or one or two-day options can help you out. And I was inclined to sell one- or two-day options myself if there was enough premium that I felt was worthwhile doing. When they do the annualized calculation I really did do an annualized calculation looking out say a week and saying well, what’s the annualized return that I’m getting on this put option price versus strike price? What’s the annualized return and trying to see if that was juicy enough trying to sell those because that time Decay is so fast during those last few days and that last week. If I own shares I could sell calls and know right away. What’s the rate of return if I get called away? That’s the worst thing that’s going to happen. I only own shares anyway. I saw this call and get called away, what’s my rate of return? And if it looks really good go ahead and do it. The same thing on the put side. Sell a put if you get assigned, you’re okay owning shares. If you don’t get assigned on the put, what does that annualized rate of return on the premium you got for the put option look like? When it’s really good and attractive, those were the traits to make. But there certainly is a time and a place to buy options like that as well if you really think a move is coming, and I think I referenced a few of these. You know, Marquis indicators before a stock is really pumping its head on an all-time high and you’re thinking this thing is going to go through tomorrow and blast off. Well, maybe then buying call options with one or two days left might be worthwhile for you. I’d say those opportunities a little further and farther in between but certainly could be something to do occasionally.
(Q) Can you please give a quick summary of when to use vertical spreads versus straddles and strangles versus butterflies? Okay, so vertical spreads versus straddles was the question? Correct, and strangles versus butterflies.
Um well, I mean that there’s somewhat different trade. Vertical spreads, and I have to isolate whether you’re buying or selling these things. Maybe the question was straddles versus Iron Butterfly? Because vertical spreads is an Iron Butterfly. So, I think maybe that’s where they’re going with that question. Why would you buy a straddle? Well the straddles are bought when you have more confidence in the move being extremely large. So, you don’t mind paying up for the straddle because your confidence level is higher. It’s a more aggressive move. If you are a little bit less certain, you think a big moves coming it’s going to be greater than the market is predicting, but you want to mitigate that somewhat lowering your costs because you know that straddles going to get crushed if the stock doesn’t move when earnings comes out. That’s when you look on the call and put side for premiums worthwhile to you and you sell it to turn it into a butterfly. And I use butterfly under the assumption that you’re going equidistant on both sides. By no means, I should have stressed this earlier, when I traded Iron Butterfly’s or used options even Iron Condors; by no means in the real world need to go out equidistant on either side. That’s the easiest way to explain the trade, but the stocks at a hundred and you want to say use an Iron Butterfly or an Iron Condor. You may think the upside or downside has more potential than the other. Often times you do, and if you want to give yourself more room to make money on one on one side or the other stagger those widths between strike prices more on one side than the other. But if you’re buying a straddle aggressive, very aggressive, if you want to turn that into a butterfly, you’re a little bit less aggressive and bringing in premium worthwhile to you. Really the same thing. I think what was the other one straddles versus what? It was vertical spreads versus straddles and strangles versus butterflies. Okay, I think I answered that. I think I answered that, if you’re doing the straddles and strangles out rights, you’re more confident. It’s more aggressive on either side long or short. Putting the other options outside of it is a way to mitigate your risk. If you have a less aggressive approach or Market Outlook, I think that answers it.
(Q) How often is IV reset?
Every second of every day. Every single time I made a trade and I was in the trading pits, for example, in the trading pits when I was busy. I might be making 100 to 300 trades during the course of a day. Every time I made a trade and I bought or sold something I was doing those two pieces of analysis that I gave earlier in the presentation. Is this what I want to do? If I’m long options, I’d like to be selling them. If I’m getting opportunities to sell out. in the pit, I left volatility alone. But I was thinking about it. If I was already long options and I was buying more, I didn’t want them, I was moving volatility immediately. When order flow came into the pit, if it was still selling to me, I didn’t want to buy any more. I’m moving volatility again. All of a sudden, I may have moved it too far and I’m getting buy orders left and right and I’m starting to sell. Well if I’m moving volatility too much, I’m just scalping against myself and I’m losing money left and right. This is why market makers lose their hair, because when you’re moving volatilities that fast, and that much, you’re scalping options against yourself if you do it the wrong way. So how often is implied volatility moving? All day every day as long as there’s trading activity. If there’s no orders coming into the pit and no trading occurring, then volatility stays right where it is, but it’s always ready to move. You can almost think of it like the market is always trying to figure out that level, that is perfect volatility, where there’s a bid and offer and nobody wants to make any trades. That’s what the market is constantly looking for and it almost never finds it because there’s always bids and offers moving the market up and down.