Here's a little dirt on volatility (“vol”). Just as love can be blind, so can friendship with this invisible force. It can pull a fast one, leaving you helpless, miserable, and eating dinner alone.
As options traders, we focus a lot on implied volatility (IV). That’s because, all other things aside, higher vol means higher options prices. So when vol is high, we may look at short option strategies that take advantage of higher option prices, such as short naked options and short vertical spreads. But in practice, it’s not enough to look at high vol and execute the strategy.
Looks Can Be Deceiving
Take a look at Figure 1. Options with four days to expiration had a vol of 90.17%—enough to make premium sellers salivate. But before you rush to judgment, take a look at the options in the next expiration. The contracts with 39 days to expiration had vol of 74.75%—not exactly low, but certainly less than 90.17%.
Now look at the prices of the out-of-the-money (OTM) calls and puts. The contracts with fewer days to expiration had lower prices than those with more days to expiration, even though the IV of contracts that were close to expiration was higher.
Remember that vol is one input into an option pricing model that makes the theoretical price of the option equal to its market price. It’s related to an option’s vega, or how much its price changes when IV changes one percentage point.
Here’s what happens: the vol calculation indirectly incorporates the option’s vega to see what the vol input into the model needs to be to make the theoretical (“theo”) option price equal to its market price. If the theo price needs to be a little higher to match the market price, the vol calculation bumps the vol input up a little if the option’s vega is high. This small increase in vol translates into a proportional small increase in the option’s price through the high vega. If the option’s vega is low, the vol calculation needs to bump up the vol input more for the option’s price to increase by that amount.
But vega isn’t constant. It’s different across strikes and expirations over time. All other things equal, an option with more days to expiration will have a higher vega than an option with fewer days to expiration. If the theo price is lower than the current market value of the option, the vol increases by a larger amount to make the theo value equal to the market price when the option’s vega is low. In other words, lower vega requires a larger change in vol input and higher vega requires a smaller change in vol input to move the theo option price a given amount.
This is why you can see some really high vol numbers for OTM options close to expiration. That’s when an option’s vega is lowest—close to expiration and far OTM. An OTM option that’s close to expiration may have a low market price, say 0.01 or 0.02. But using a vol of the at-the-money (ATM) option, for example, might make the theo value of that OTM option worth less than 0.01. So, because the OTM option’s vega is so low, the IV calculation has to increase the vol input much higher than the ATM vol to give that OTM option a theo value of 0.01.
If your strategy involves selling options that have a high IV, you might find the highest vols for OTM options close to expiration. But if you sell them, the credit you can get might not even cover the commission expense, which would make it impossible to make money on the trade.
Don’t let high IV fool you into thinking you can make a quick buck. You may consider vol your friend. But vol’s larger circle of friends may include ones you don’t know so well, like vega.