A lesson on “implieds”…..

Posted on 08/10/2011

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im·plied

  /ɪmˈplaɪd/ Show Spelled[im-plahyd] Show IPA

adjective

 
involved, indicated, or suggested without being directly or explicitly stated; tacitly understood: an implied rebuke; an implied compliment.
 
First off, thanks very much for the positive responses to the writing I’ve done to this point. It’s rewarding to know that a few people read and actually enjoy my drivel……
 
Well, in the world of options trading, implied vols mean EVERYTHING (at least in my opinion) precisely because it’s the ONE unknown variable in the derivative pricing model.
 
Options are derivatives because their value (price) is dependent upon the value of something else. Their value is “derived” from  5 or 6 imputs (depending on whether a product is dividend paying), specifically:
 
Price of underlying (stock, index, commodity, etc.) – this is KNOWN.
Time until expiration – this is KNOWN.
Interest rate – this is KNOWN (it used to change, but after yesterday’s FOMC meeting, it looks like more of a “constant”)
Strike price – this is KNOWN.
Dividend – this is KNOWN (but subject to change).
Volatility – this is the GREAT UNKNOWN.
 
We have historical (backwards looking) measures for volatility and they are helpful in determining expected future volatility. Some products typically trade at a discount to historical volatility, but most trade at a small premium to historical. On July 5th, when talking about the market (and the S&Ps were flirting with 1340 again) I said:
 
S&P implied vols trading at a discount to historical, which from my perspective warrants caution on the downside, particularly given the market’s impressive advance over the past two weeks. We went from testing (for a second time in June) the all important 200 day moving average to flirting with the May (multi year) highs in short order.Furthermore, newsflow out of the ratings agencies (Greek rollover plan in current form – tantamount to a default? Portuguese downgrade) very high margin levels (historically), lack of passive money inflows (beginning of month), and the constant debt ceiling overhang (less than a month to go with Congressional gridlock) could lead to a quick backfill.52 week cash VIX lows (14.30) made in late April (with S&Ps trading ~ 1370 ) and current cash VIX just over 16 and market trading just below 1340.  Do we have the conviction to make new highs? When NFLX is your market leader…… I think caution is recommended.
 
This is a great time to point out that hindsight makes this very easy, but my point is MANY people trade options based purely on PRICE. Stock XYZ is here, the S&Ps are here, Crude is here, Gold is here, whatever……..but the most successful option traders I’ve been around (and I’ve been around quite a few – and I’ve had stretches of considerable success myself) trade IMPLIED VOLATILITY. Period.

Price is just a number. $50, $500, $0.50, who cares? You should know what vol you are buying or selling and why.

Let’s go back to July 28th, when I recommended a short strangle in Silver because I believed implieds were too high relative to historical.

Generally, Silver options trade at a slight premium to historical (10/20/30 day) volatility. For example, if 20 day historical vol is 39 1/2 (which is about right now), options may trade around a 41 or 42 implied vol (premium to historical). Once in a while SI options will trade at a discount to historical, in which case premium is probably a buy (or at least not something you should be short).

Right now the spread between historical (realized) vol and implieds is wide. September options expire in 28 days (August 25th) and 30 day historical (realized) vol is 37%.  However, September implieds are selling around a 43 vol, so the spread is +6. Make sense? In my opinion, a +3 is “fair value”.

As such, I said sell the 45 call AND sell the 35 put in September (expiration Aug 25) and collect 65 cents. I recommended having .05 bids for either side because of the law of diminishing returns (tempt fate being short .05).

Silver was trading around $39.80 when I recommended the position. It’s 13 days later and Silver is $39.35 – we should be in great shape right? Two weeks worth of decay and the underlying very near where we put position on……WRONG! That position was selling at 43 implied vol and vol traded as high as 57 in Silver this week.

Today the 45 calls settled at .27 and the 35 puts settled at .38, so the strangle that we sold for .65 is STILL WORTH .65 TWO WEEKS LATER even though Silver (underlying) is largely unchanged.

Bottom line – volatility expectations are a GUESS and the drivers in any market can change rapidly.

Your State Farm underwriter/actuary has a good idea of how likely you are to have an accident based on some sample/historical data (knowns – age, gender, driving record, etc.). The premiums you pay are quoted accordingly.

The S&Ps were cruising along with a tank full of speculative money created by the Federal Reserve and they just ran into the median on I-90 during rush hour. It ain’t pretty and it sure as hell isn’t cheap to insure anymore.

Trade accordingly.

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