Why Options Traders Must Watch Implied Volatility
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A reader – Thom questioned why I recommended you short the Lehman stock as opposed to buying puts. My rational is that the options are extremely expensive. Imagine buying the options at the peak of volatility and then it drops, say by 30%. Even if Lehman stock drops, you have a high probability that you will still lose money on your puts as the puts become less costly to purchase due to the lower volatility.
Below (chart 1) is a chart of the current price. Above is the stock price; below the option price. As you can see the stock has fallen, but so has the put option over Monday/Tuesday. Why? Over that period, the implied volatility fell from roughly 115 to 75. This is the drop in vaolatility that I was afraid of. Had you shorted the stock through the period, you would have made money. Had you bought puts, you probably lost money through this period. Today the stock went up and correspondingly the put optino went down, but the thing to keep in mind is that on Monday/Tuesday puts lost money due to a fall in implied volatility (chart 2)
chart 1 – stock falls on Mon/Tues, but puts also fall
When buying options, pay attention to the implied volatility! It is a big factor in option pricing.
Chart 2 – Implied Volatility falls from a peak of 200 to 75 today. Puts fall through Mon/Tues.
8 Comments on this post
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Agung said:
Excellent post. I was wondering why I lose in options sometimes even when my stock does exactly what I expect it to. I will definitely do more education in options. Any other finance stocks ideas?
April 3rd, 2008 at 11:38 pm -
Dax Desai said:
Thanks. I’m glad it is useful. I will post a few more financial picks over the weekend.
April 3rd, 2008 at 11:42 pm -
Slug said:
Nice explanation. Would you have enhanced a trade on Mon/Tues with a short sell AND buying calls or would the call price have suffered due to the same volatility argument? I assume it would have.
April 4th, 2008 at 12:11 pm -
Dax Desai said:
Slug – I would not have bought calls because of the same volatility argument. Calls would have been expensive and as the volatility eventually dropped, the calls would have seen downward pressure. Now if the stock movement is enough, then you could still make money. I personally don’t like to be going uphill in my trades. I could have been completely wrong and the volatility could have stayed high in which case you would have made money on Wed.
April 4th, 2008 at 2:20 pm -
Andy said:
Good advice. I have been reading about the alpha, beta’s and gammas as I try to learn about option trading and it all comes down to volatility and time value. Options are great tools to make real wealth or loose everything very fast. I am going to be writing about my experience to date in an upcoming post at – http://www.savingtoinvest.com – and will include a link back here.
April 4th, 2008 at 8:04 pm -
Siva said:
When IV is high and ig your expect it to come down, Credit spreads are better. If you are bearish, sell call spread (something like sell 60 call and buy 70 call, same month).
If you are bullish, sell put spread.
Neutral, do condor by selling both otm call spreads and put spreads.
Another way if neutral is to do ATM butterfly.
In all cases IV drop will halp a lot to the option position.
hope this helps.
April 5th, 2008 at 7:47 am -
Steve said:
But one would think that the positive effects of delta would be enough to outweigh the reduction of implied vol (vega) and the passing of time (theta)?
September 9th, 2008 at 5:54 pm -
The World's Worst Stock Picker said:
Another factor in option pricing that is often overlooked is the liquidity of the options themselves. Options that have low volume usually have very nasty bid/ask spreads that puts you at the mercy of the market maker.
In a high volatility environment the best way would be to do bear and bull vertical spreads and volatility does not matter as much as if you were doing for example a calendar spread.
September 12th, 2008 at 7:55 am
