Option�s TIME VALUE � Putting It Together � Part 4: Behavior

The Behavior of Time Value
As mentioned in Part 3, the Time Value component of an option price will decline or �erode� as expiration is nearing (i.e. Time Decay).

The rate of decline of option�s time-value resulting from the passage of time (i.e. rate of Time Decay) is known as THETA, which is one of the Options Greeks.

Comparing Theta at a certain point of time between ATM (At-The-Money), ITM (In-The-Money) & OTM (Out-of-The-Money) options, Theta is typically highest for ATM options, and gradually decreases as options move towards ITM and OTM.
This is understandable because ATM options have the highest time value component, so they have more time value to lose over time than an ITM or OTM option.

Comparing Theta over time, there are different behaviors between ATM and ITM / OTM options:
For ATM options, as the Time Value component of an option price decreases when the option is approaching expiration, the rate of time value decrease is accelerating (i.e. Theta is increasing) as it is getting closer to expiration.
This means that the amount of time value disappearing from the option price per day gets bigger with each passing day. For ATM option, time value decreases sharply particularly in the last 30 days before expiration.

On the other hand, for both ITM & OTM options, Time Value actually decreases at a decelerating rate as expiration nears. In other words, Theta decreases as the option is approaching expiration.
This means that the amount of time value disappearing from the option price per day gets smaller with each passing day.

This Time Value behavior can be seen in the following graphs:

1) Time Value of ATM Option:






2) Time Value of OTM Option:




Note: Both pictures courtesy of Sigma Options

Therefore, based on the above, we can summarize as follow:

For ATM options, Theta (i.e. the rate of time value decline as the time passes) is typically the highest (as compared to ITM & OTM options), and will be increasing (i.e. the rate of time value decrease is accelerating) as the option is nearing expiration.

For both ITM & OTM options, Theta is relatively lower (than ATM options), and will be decreasing (i.e. the rate of time value decrease is decelerating) as the option is nearing expiration.

The Impact of Implied Volatility (IV) on THETA
Theta will also be affected by the changes in Implied Volatility (IV).
When IV decreases, Theta will be higher, particularly when it is nearing to expiration.
On the other hand, when IV increases, Theta would be lower.

Why is it so?
As previously discussed in Part 1, the level of Time Value of an option could basically be associated with the level of uncertainty as to whether or not an option can finish ITM.
The more uncertain as to whether an option can or cannot finish ITM before or at expiration, the higher the time value will be.

When Implied Volatility decreases and the option is nearing to expiration, such uncertainty will be lower.
Since Theta is the rate of time decay, when IV decreases, Theta will be higher (i.e. the rate of time value decrease due to the passage of time will be faster).
This is because higher Theta would consequently result in lower time value, which reflects the lower level of uncertainty due to lower Implied Volatility.
And this is particularly so when the expiration is nearing, because the underlying stock price will have lesser time to move, and therefore have even lower probability to finish ITM (i.e. even lower level of uncertainty).

Related Topics:
* FREE Trading Educational Videos You Should NOT Miss
* Options Trading Basic � Part 1
* Options Trading Basic � Part 2
* Understanding Implied Volatility (IV)
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Main Factors that Affect Option�s TIME VALUE

As mentioned in �Option Price Components�, option price or premium consists of:

For ITM Option:
Option Price = Intrinsic Value + Time Value

For ATM and OTM Options:
Option Price = Time Value

Whereas:

Intrinsic Value of ITM CALL Option:
Intrinsic Value = Current Stock Price � Strike Price.

Intrinsic Value of ITM PUT Option:
Intrinsic Value = Strike Price � Current Stock Price.

As you can see from the above formula, Intrinsic Value of an option is very straightforward.
It�s simply the difference between option�s strike price and current stock price.
Time Value component of an option is the one that make an option very complicated to understand.

Time Value of an option would be mainly affected by:

1) Degree of Options Moneyness
As discussed in this post, Options Moneyness describes the relationship between an option�s Strike Price with stock price (i.e. where the Option�s Strike Price is in relation to the current stock price).

The farther the option�s Strike Price to current stock price, the lower the time value will be.
Therefore, since for ATM options, the option�s Strike Price is the same as the current stock price, ATM options would consequently have the highest time value.
The time value will gradually decline as it moves to deeper ITM and deeper OTM options (like inverted-U curve), because the deeper ITM or OTM an option, the farther its Strike Price from the current stock price.

2) Implied Volatility (IV)
The higher the IV, the higher the option�s time value.

3) Time Remaining to Expiration
The longer the time remaining to expiration, the higher the option�s time value.
All other things being equal, an option with more days to expiration will have more time value than an option with fewer days to expiration.

Hence, Implied Volatility (IV) is not the only one that influences an option�s time value. That�s why although, for instance, IV of an option is very much higher than the other options, it does not mean that its premium will be higher in terms of dollar value. There are other factors affecting their overall premium.

Just remember that whether an option is considered �cheap� or �expensive�, it is not based on the absolute dollar value of the option, but instead based on its IV.
When the IV is relatively high, that means the option is considered �expensive�.
On the other hand, when the IV is relatively low, the option is considered �cheap�.
(Please see this post � How To Determine If An Option Is Cheap (Underpriced) Or Expensive (Overpriced) � for further discussion).

However, the overall option price / premium in absolute dollar value will be determined by other factors as discussed above.
Therefore, it�s possible that an option is low in terms of dollar value, but it�s considered �expensive� due to relatively high IV.
On the other hand, an option can be high in terms of dollar value, but it�s considered �cheap� due to relatively low IV.

Related Topics:
* FREE Trading Educational Videos You Should Not Miss
* Options Trading Basic � Part 1
* Options Trading Basic � Part 2
* Understanding Implied Volatility (IV)
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* Learning Charts Patterns

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�Deeper OTM Puts are considered as �most expensive� options�: What Does This Really Mean?

In my post �Volatility Smile and Volatility Skew � Part 1�, it is mentioned as follows:

For Put options, the Implied Volatility is typically the highest for deep OTM options and then is decreasing as it moves towards ITM options.

In other words, generally the �most expensive� options are deep ITM Calls and deep OTM Puts.

For Put options, the possible reason why people are willing to buy an �expensive� deep OTM Puts are that they are viewed as a form of �insurance� against market crash. The lower cost in terms of dollar might also offer another reason for deep OTM Puts to serve as an insurance / protection tool of one�s portfolio.

As discussed earlier in this link, an option is deemed cheap or expensive not based on the absolute dollar value of the option, but instead based on its IV.
When the IV is relatively high, that means the option is expensive, whereas when the IV is relatively low, the option is considered cheap.

For deep ITM Calls, even without understanding the above concepts, people won�t really question why they are deemed �most expensive�, as the options premiums are also higher in terms of dollar.
However, for deep OTM Puts, those who are not aware the above concepts will be wondering why deep OTM Puts is considered �most expensive�, as the options premiums are actually low in terms of dollar value.

In this post, we�ll focus on discussing OTM Puts, by comparing less-deeper and deeper OTM Puts.

As deeper OTM Puts normally have higher IV than less-deeper OTM Puts, deeper OTM Puts are therefore considered as "more expensive".
However, this does not mean that the premium of deeper OTM Puts will be higher in terms of dollar.

This is because an option's premium is affected by 6 factors, not only IV.
As discussed in the previous post (i.e. Options Pricing), other important factors that determine option�s price are option�s strike price & current stock price.

Although deeper OTM Puts is higher in IV (and hence it's considered "more expensive"), their option premium will be lower in terms of dollar than less-deeper OTM Put options.This is because deeper OTM Put options' strike prices will be much farther from the current stock price, as compared to less-deeper OTM Puts would.
As a result, deeper OTM Put options will have much lesser chance / probability (almost no chance) of becoming �In-The-Money (ITM)� before expiration. Or in other words, it is almost certain that the deep OTM options will not finish ITM.

Remember that for OTM options, option premium will only consist of Time Value component.
(Please see this post � Option Price Components � in case you need more clarification).

As previously mentioned in this post (More Understanding about Options Time Value):

Time value can be viewed as �the price that people are willing to pay for the chance / uncertainty as to whether or not an option will finish In-The-Money (ITM)�.
The more uncertain, the higher the time value will be.

An option that is far OTM has almost no chance of finishing ITM. As such, it will not command a high time value.
An option that is already deep ITM is almost certain that it will finish ITM, hence time value is smaller.
But ATM or near ATM options have more uncertainty as to whether or not the options will finish ITM, and therefore these options have a higher time value.

Hence, in this case, higher IV increases the time value of deeper OTM Puts. However their overall premium will be lower than less-deeper OTM Put options in terms of dollar, particularly because of lower uncertainty (almost no chance) of the deeper OTM Puts to finish ITM before expiration, as they have farther option�s strike price from current stock price.

To understand more about other aspects of Implied Volatility, go to: Understanding Implied Volatility (IV).

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* Options Trading Basic � Part 2
* Option Greeks

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Volatility Smile and Volatility Skew � Part 5: Strike Skew vs. Time Skew

Go Back to Part 4: Volatility Smile and Skew Implications

Strike Skew vs. Time Skew
Actually, there are 2 types of volatility skews: Strike Skew and Time Skew.

1) Strike Skew, or sometimes called Vertical Skew, is obtained by plotting Implied Volatility of an option with the same expiration month across various strike prices.
This is the most common type of Volatility Skew.
The volatility skew that has been discussed so far in the previous posts is Strike Skew.

2) Time Skew, or sometimes called Horizontal Skew, is obtained by plotting Implied Volatility of an option with the same strike price across various expiration months.
This kind of volatility skew might be seen as an indicative of market�s future expectations on a stock.

Generally speaking, it is possible for options with any expiration month to have higher IV levels than options with the other expiration months.
Because this volatility skew is mainly driven by expected price movement surrounding an impending news event that may significantly affect the stock price.
These skews can arise and disappear as the news event approaches and then passes.

Nevertheless, the typical time skew pattern observed is higher IV for options with shorter time to expiration than for longer-time-to-expiration options.
One possible reason is that most speculators are probably more interested in betting on �surprises� that are expected to occur in shorter term than those in longer term.
As such, they would also prefer options with shorter time to expiration, as these options are lower in terms of dollar value (as it carries less time value than longer-time-to-expiration options), and hence can potentially provide higher % returns when the extreme price movement does take place as expected.
This would consequently increase demand for shorter time options, and hence push the options� price up through higher IV.

To understand more about other aspects of Implied Volatility, go to: Understanding Implied Volatility (IV).

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* Options Trading Basic � Part 1
* Options Trading Basic � Part 2
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Volatility Smile and Volatility Skew � Part 4: Implications

Go Back to Part 3: Why Volatility Smile and Skew Happen.

Implications of Volatility Smiles
In some cases, volatility charts of an option may shift over time from Volatility Skew to Volatility Smile, or vice versa.
When volatility charts of a particular stock�s options show a shift from Volatility Skew to Volatility Smile, this may signal an increased speculators� interest into that stock, implying a possibility of volatile price movements for that stock due to certain reasons. (Please refer to Part 3 for more explanation).
For an options trader, this might offer some trading opportunities in order to take advantage of the potential volatile price movement. For instance, by buying straddle or strangle.

In addition, with the same logic, when an option of a stock displays Volatility Smiles, this stock is expected to be more volatile than a stock that displays a Volatility Skew pattern.
This might also provide some useful information/insight for the traders/investors in their investment decision.

Volatility Smiles and Time Remaining To Expiration
Volatility Smiles seem to be more likely to occur for options with shorter time to expiration.

When extreme price movements are expected to happen for a stock in the near term (which leads to huge interests in speculative trading for that stock), most speculators would more likely choose options with shorter time to expiration.
This makes sense as options with shorter time to expiration are lower in dollar term (as it carries less time value than longer-time-to-expiration options), and hence could potentially provide higher % returns when the extreme price movement does take place as expected.

Therefore, Volatility Smiles may particularly be observed in options nearing to expiration of a stock that is expecting big moves from pending news in the near term, due to heavy speculative trades during that period.

Calculating Estimated Option�s Price Using Options Calculator / Pricer
Since Implied Volatilities vary across different strike prices, it is therefore important to use the respective IV values for a particular strike price when we are calculating an estimated option�s price using options calculator / pricer (e.g. for calculating estimated options price for a stop or price target).
Otherwise, the accuracy of the estimated option�s price will be greatly affected.

Continue to Part 5: Strike Skew vs. Time Skew

To understand more about Implied Volatility, go to: Understanding Implied Volatility (IV).

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Volatility Smile and Volatility Skew � Part 3: Why Volatility Smile and Skew Happen

Go Back to Part 2: Understanding Volatility Smile & Volatility Skew

Why Do Volatility Smile & Volatility Skew Happen?

As mentioned in Part 1, in more recent years, Volatility Skew pattern are more commonly observed than Volatility Smile pattern.

For Call options, the Implied Volatility (IV) typically displays a Volatility Skew pattern, whereby IV is the highest for deep ITM options and then is decreasing as it moves towards OTM options.

As discussed earlier, traders/investors are willing to buy an �expensive� deep ITM Calls because they can be used as a leverage tool to gain higher % return with lower capital, as compared to invest in the stock itself. Since deep ITM Calls have delta close to 1, they works like stocks, moving almost dollar for dollar with the stock price, but with much lower capital.
In addition, when extreme price movements are expected, this may also mean that stocks can move sharply to the opposite direction. When the stock prices do not move as expected, ITM options would have lower risk of losing all the money than would ATM and OTM options, due to their inherent intrinsic value.

In contrast, for Put options, the IVs also display a Volatility Skew pattern, whereby IV is the highest for deep OTM options and then is decreasing as it moves towards ITM options.
As mentioned previously, the possible reason why people are willing to buy an �expensive� deep OTM Puts are that probably they are viewed as a form of �insurance� against market crash.
In addition, deep OTM Puts are also considered low cost in terms of dollar; hence this might offer another reason why the deep OTM Puts are quite widely used as an insurance / protection tool of one�s portfolio.


Although Volatility Skew is the typical volatility pattern observed most of the time, sometimes Volatility Smile may appear due to some reasons. And the appearance of Volatility Smile might carry some signals to the market.

Volatility Smiles might indicate that the market is expecting a high possibility of extreme stock price movements as result of either increased volatility in the overall market or in a particular stock.
This might arise in anticipation of corporate news announcements or any pending news that will potentially result in a volatile movement in the stock price.

When big movement in stock price is highly possible, OTM options are more likely to become the ITM options. When this really happens, OTM options will produce higher % return than ATM and ITM would. Moreover, OTM options are lower in terms of dollar. This kind of situations may attract speculators to rush and bet into the market by buying OTM options in order to take advantage of the potential extreme movement in stock price.

Under these circumstances, the speculators would be willing to pay a �higher� price for OTM options as well. This would then drive the price of OTM options upwards through increased IV.
As a result, when plotted into the chart, the IV would show a Volatility Smile pattern, whereby the IVs of both ITM and OTM options are higher (more �expensive�) than the IV of ATM options.

Continue to Part 4: Implications of Volatility Smile & Volatility Skew

To understand more about Implied Volatility, go to: Understanding Implied Volatility (IV).

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Volatility Smile and Volatility Skew � Part 2: More Understanding

Go Back to Part 1: Description

What Do Volatility Smile and Volatility Skew Mean?
As you know, an option�s price comprises of Intrinsic Value and Time Value.
In options pricing, there are 6 factors that affect an option�s price: option�s strike price, underlying stock price, implied volatility, time to expiration, interest rate, and dividend.
An Intrinsic Value of an option is determined by the option�s strike price and the underlying stock price.
And the major determinant of option�s Time Value is Implied Volatility and time remaining to expiration.

Since Implied Volatility (IV) represents an estimate of future volatility, this factor is the most subjective. Therefore, Implied Volatility has been used by the market makers to �manipulate� the option�s price in order to balance the demand vs. supply of an option.
For instance, when the demand of a particular option is relatively higher than its supply, traders/investors will be willing to pay a �higher� price for that option. This high demand would in turn push the price of that option upwards (through increased IV), resulting in higher profit for the market makers from higher time value as a compensation for higher risks that they have to bear.

Hence, a Volatility Smile chart suggests that both ITM and OTM options are in higher demand (relative to their supply) than ATM options. Traders/investors are willing to pay a �higher� price to buy OTM and ITM options (through higher IV) than to buy ATM options.

It is important to note that �higher� price here does not mean higher in terms of dollar value.
ITM options will always be higher in terms of dollar value than ATM and OTM options, due to its Intrinsic Value.
However, OTM options could be �more expensive� than ATM and ITM in relation to their Implied Volatility.
In other words, the measure of an option�s expensiveness is its Implied Volatility.

As discussed earlier, the option is considered �expensive� when the IV is relatively high.
On the other hand, the option is considered cheap when the IV is relatively low.

Likewise, a Volatility Skew chart whereby IV values are higher for ITM options and then is declining as it moves towards OTM (i.e. for Call options), for instance, suggests that the demand for ITM options is relatively high and traders/investors are willing to pay a �higher� price to buy ITM options.

On the contrary, a Volatility Skew chart whereby IV values are higher for OTM options and then is decreasing as it moves towards ITM (i.e. for Put options) suggests that the demand for OTM options is relatively high and traders/investors are willing to pay a �higher� price to buy OTM options.

Continue to Part 3: Why Volatility Smile & Volatility Skew Happen

To understand more about Implied Volatility, go to: Understanding Implied Volatility (IV).

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Volatility Smile and Volatility Skew � Part 1: Description

Previously, we�ve talked a bit about Volatility Smile and Volatility Skew in this article.

Basically, Volatility Smile and Volatility Skew show that even for the same expiration month, Implied Volatilities (IVs) can vary by strike price.
We can get Volatility Smile or Volatility Skew charts by plotting the IV values of options for the same expiration month across various strike prices.

For some options, given the same expiration month, the IVs of In-The-Money (ITM) & Out-of-The-Money (OTM) options are higher At-The-Money (ATM) options.
As a result, when the IVs for various strike prices are plotted into a chart, it would take shape approximately like a U-pattern, which is by glance, it looks like a smile.
As such, this kind of chart is often known as �Volatility Smile�.

Some options may have higher IV for more ITM options, and then is decreasing as it moves towards OTM options.
On the other hand, other options might have higher IV for more OTM options, and then is declining as it goes towards ITM options. Such patterns are often called �Volatility Skew�.



In one paper on �Volatility Smile�, Don Chance suggested that the relationship between Implied Volatility and Option�s Strike Price has been documented since at the least the 1987 market crash.

When first observed, the relationship between the two variables took shape as a Volatility Smile. However, in more recent years, the Volatility Smiles have mostly disappeared, and Volatility Skews are more commonly observed.

The typical volatility patterns observed recently are as follow:

For Call options, the Implied Volatility is typically the highest for deep ITM options and then is decreasing as it moves towards OTM options.

For Put options, the Implied Volatility is typically the highest for deep OTM options and then is decreasing as it moves towards ITM options.

In other words, generally the �most expensive� options are deep ITM Calls and deep OTM Puts.

As to the reasons why certain options are �more expensive� than the others, Don Chance said that actually no one really knows.

For Put options, the possible reason why people are willing to buy an �expensive� deep OTM Puts are that they are viewed as a form of �insurance� against market crash. The lower cost in terms of dollar might also offer another reason for deep OTM Puts to serve as an insurance / protection tool of one�s portfolio.

For Call options, the possible reason why traders/investors are willing to buy an �expensive� deep ITM Calls are that they can be used as a leverage tool to gain higher % return with lower capital rather than to invest in the stock itself. Because deep ITM Calls have delta close to 1 and hence it works like stocks, moving almost dollar for dollar with the stock price, but with much lower capital.

Continue to Part 2: More Understanding of Volatility Smile & Volatility Skew

To understand more about Implied Volatility, go to: Understanding Implied Volatility (IV).

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What To Consider When You Are Buying An Overpriced (High IV) Options

In the previous post, we discussed that when IV is relatively low (option is cheap) and is expected to rise, we should buy options (i.e. consider options strategies that allow us to be an option buyer).
On the other hand, when IV is relatively high (option is expensive) and is expected to drop, we should sell options (i.e. consider options strategies that allow us to be an option seller).

However, often we�d like buy options despite the relatively high IV (i.e. options is considered expensive).
For example, for myself, I like playing directional swing trading to take advantage the expected price movement for 1 � 3 days. Hence, in this case, I�ll just buy straight call or put options depending on the expected direction. However, frequently the option is relatively high in IV (�expensive�). Is it all right if I buy the options?
To me, buying options when IV is high is still all right.
However, there are a few things to consider when buying options with high IV:

1) As mentioned earlier, usually IV is high because we're expecting certain events that can cause the drastic price movement (e.g. earnings announcement, FDA approval, M&A, etc.). Before that event happens, the IV normally will not drop drastically, and is also quite likely to rise even higher and peak on the day of the event itself.
So, if I'd like to play swing trading or day trading, I have to make sure that I close my position (sell the options) before the event take places.

2) Assess the Reward / Risk ratio of a potential trade by having different scenarios of IVs, expected / target stock prices & time remaining to expiration (using Options Calculator / Pricer).
By inputting different IV numbers (e.g. the highs, lows, or average, etc.) as a parameter in the Options Calculator / Pricer, you can see how IV can potentially affect your trade under different scenarios.
This could also help you to assess whether it�s better to use ITM (In-The-Money), ATM (At-The-Money), or OTM (Out-of-The-Money) options.
As discussed previously on more understanding about IV, ATM and OTM options are more affected by IV movement than ITM options.

(You can refer to the link for more discussion on how to get IV data)

3) Some traders like to bet with options over the events that can cause the drastic price movement (e.g. earnings announcement, FDA approval, M&A, etc.).
In this case, we have to bear in mind that some degree of price movement has been priced in with the high IV. So, when IV drops considerably right after the announcement, we can only gain if the price movement is big enough to offset the drop in IV. Otherwise, we'll lose money with options even though the stock price moves to the expected direction.
(As discussed more detail in this post).

4) When IV is relatively expensive and you don�t want your options to be affected too much by the IV changes, you may want to consider buying further ITM (In-The-Money) options.
Remember that IV has a considerable effect on the option price, but it affects only the time value component of an option's price, not on the Intrinsic Value
(Please refer to this post: More Understanding About Implied Volatility).
Therefore, the deeper ITM options will be less affected by the changes in IV, as it has less time value component in the option price. The further ITM an option, the lesser time value component it has.

To understand more about Implied Volatility, go to: Understanding Implied Volatility (IV).

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Example On How Implied Volatility (IV) Affects Option�s Price Significantly

As discussed earlier, in options trading, Implied Volatility (IV) has a considerable impact on an option�s price. An option�s price can go up or down due to changes in IV, although there is no change in the stock price. Some times, for instance, we also find a stock price has increased, yet the Call option of the stock did not increased, but it dropped instead.
Now, let�s see a simple example on how IV affects an option�s price considerably.

In the prior post, it�s shown that IV will normally begin to rise starting from a few weeks before the announcement day. And once the announcement is out, the IV will drop significantly.

The fact that the IV will drop considerably right after the announcement is extremely important to note, particularly when you�re trading options by buying straight call / put options (directional play) or buying strangle / straddle (non-directional play) over earnings announcement.
This is typically the reason why you might see that the stock price has gapped up / down in your direction, but yet the option�s prices do not move profitably.
Why is it so?
Remember that, for both Call & Put options, an increase in IV will increase an option�s price, whereas a decrease in IV would decrease an option�s price.
(You may want to refer to the posts on Vega or Options Pricing for further discussion).

The increase in IV before the earnings announcement is to �anticipate� the volatility as a result of the announcement. In other words, certain magnitude of the price movement (either up or down) has been �priced in� by the increase in IV, which causes the option�s price to be more �expensive� than normal.
Once the announcement is out, the IV will drop significantly, which would affect the option�s price negatively.

Therefore, to be profitable in such cases, the increase / decrease in stock price must be big enough to offset the negative impact of the drop in IV on option�s prices.
And for strangle / straddle, the stock price movement must be even much bigger in order to offset both the drop on option�s prices at both legs (call & put legs) due to the drop in IV as well as the drop on option�s price at the other leg after the stock price moves to certain direction.

Therefore, in this case, it�s important to first assess the Reward / Risk ratio of a potential trade by inputting different scenarios of IVs and expected / target stock prices (using Options Calculator / Pricer).
By doing this, you can anticipate what your best & worst scenarios are, have your risk & return calculated, and determine if the trade is worth taking.

To understand more about Implied Volatility, go to: Understanding Implied Volatility (IV).

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The Behavior of Implied Volatility (IV) & Historical Volatility (HV) Before & After Earnings Announcement

As mentioned before, Implied Volatility (IV) does factor in future important events / news which are expected to move the option�s price considerably within the next 30 trading days (e.g. earnings announcement, FDA approvals, etc.).

For some regular events, such as earnings announcement, which typically take place on a quarterly basis, we could see some common behavior before & after the announcement.
Generally, IV would normally start to increase since a few weeks before the announcement day.
Once the announcement is out, the IV will usually drop significantly.
On the other hand, the Historical Volatility (HV) may rise drastically should there were a significant gap up / down in stock price after the announcement.

Example:





Note:
RIMM�s Earnings Announcement: 28 Sep 06, 21 Dec 06, 11 Apr 07, 28 Jun 07, 4 Oct 07.

As we can see from the chart, the IV (Implied Volatility) was normally increasing when the announcement approached, and it dropped significantly right after the announcement.

On the contrary, when there was a significant price gap (up / down) after the announcement, the HV (Historical Volatility) increased drastically, reflecting the sudden actual price movement (e.g. Price gapped up after earnings announcement on 28 Jun 07).
Also notice that about 30 trading days after that, HV fell drastically. This is because the price data on the day just before the price gap occurred has been excluded from the HV calculation. (Remember that HV is a measure of the fluctuations of the stock price over the past 30 trading days).

Next, what�s the impact of the above behavior when we�re trading options over the announcement? We�ll discuss it further later. Please stay tune. :)

To understand more about other aspects of Implied Volatility, go to: Understanding Implied Volatility (IV).

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How To Determine If An Option Is Cheap (Underpriced) Or Expensive (Overpriced) � Part 2

Go back to Part 1.

How To Determine If IV is High or Low? (Cont�d)

Example:



Picture courtesy of: ivolatility.com

For AAPL, the IV figures (gold colored line) range between 24% to 54%.
The peaks / highs of the IV charts are around 45% - 55%. When the IV is relatively high for the stock, that means the option�s price is relatively expensive.
On the other hand, the bottoms / lows of the IV charts are about 25% - 30%. When the IV is relatively low for the stock, that means the option�s price is relatively cheap.
The area between 35% - 40% seems like the average area. Hence, when IV is around this area, the option�s price can be considered quite �reasonable�, not �expensive� or �cheap�.
Notice that when the IV is at the peak or at the bottom, it tends to move back towards its average area.

Implied Volatility (IV) & Options Strategy Consideration
When IV is relatively low (option is cheap) and is expected to rise, buy options (i.e. consider options strategies to take advantage of the expected move that allow us to be an option buyer).
For example:
You expect the price to go up in the near term. Currently, the IV is also relatively low and it�s expected to increase, as it is approaching earnings announcement in a few weeks ahead. When you buy Call options, the option�s price could increase not only due to the rising stock price, but also as a result of the rising IV. Even when the price stays flat, the option�s price might still increase due to the increase in IV.
Buying Straddle or Strangle also can benefit from the rising IV.

When IV is relatively high (option is expensive) and is expected to drop, sell options (i.e. consider options strategies to take advantage of the expected move that allow us to be an option seller).
For example:
When you�re bullish, you may want to consider a Bull Put Spread, which allow you to sell options (and collect premiums) with a limited risk.
On the other hand, when you�re bearish, you can consider a Bear Call Spread.

To understand more about other aspects of Implied Volatility, go to: Understanding Implied Volatility (IV).

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How To Determine If An Option Is Cheap (Underpriced) Or Expensive (Overpriced) � Part 1

As discussed before in the previous post, in options trading, Implied Volatility (IV) has a huge impact on an option�s price.
An option�s price can move up or down due to changes in IV, even though there is no change in the stock price.
Some times, for instance, we also find a stock price has gone up, however the Call option of the stock did not increase, but it decreased instead. This kind of case is not surprising if we understand the factors that affect an option�s price. The reason why this phenomenon happens is usually due to a drop in IV.

Therefore, before we buy or sell an option, it is important to check if an option is relatively cheap (underpriced) or expensive (overpriced).
An option is deemed cheap or expensive not based on the absolute dollar value of the option, but instead based on its IV.
When the IV is relatively high, that means the option is expensive.
On the other hand, when the IV is relatively low, the option is considered cheap.

How To Determine If IV is High or Low?
Often, we come across some articles which suggested the way to evaluate if an option is cheap (underpriced) or expensive (overpriced) is by comparing IV against HV at a particular point of time.
When IV is considerably higher than HV, it means an option is expensive. On the contrary, when IV is much lower than HV, an option is considered cheap.

However, the problem is that IV is hardly related to HV, because IV is a prediction of stock�s future fluctuation for the next 30 trading days, while HV is a measure of stock�s fluctuation over the past 30 trading days. IV usually takes into account news or the coming important events. When an important event is expected to happen in the next 30 days (e.g. earnings announcement, FDA approvals, etc.), Implied Volatility will be relatively high. However, this may not be reflected in the �what has happened� during the past 30 days. Therefore, actually we can�t really compare IV vs. HV figures at a particular point of time.

To determine if an option is cheap (underpriced) or expensive (overpriced), IV figure at a particular point of time should be compared against its past IV trend.
Typically, IV (and HV as well) will oscillate from a period of relatively low volatility to a period of relatively high volatility. When IV is relatively high or low, normally it will tend to move back towards its average value. This pattern can be used to assess the reasonableness of an option�s price.

We�ll discuss an example and how to advantage of IV movement in Part 2.

To understand more about Implied Volatility, go to: Understanding Implied Volatility (IV).

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Understanding Implied Volatility (IV)

Just want to get more organized�.
As you know, understanding volatility is very critical in options trading.
I�ve previously written some posts on IV & HV. I�ll put the links of all posts on this topic below, and place this on the top left corner for easier future reference.

Click the following links to read each of the posts:

1) Historical Volatility (HV) vs. Implied Volatility (IV): Definition

2) How To Get Historical Volatility (HV) vs. Implied Volatility (IV) Information:
a) How To Get HV vs. IV Info � Part 1
b) How To Get HV vs. IV Info � Part 2

3) Relationship between Historical Volatility (HV) and Implied Volatility (IV)

4) More Understanding About Implied Volatility (IV)

5) How To Determine If An Option Is Cheap (Underpriced) Or Expensive (Overpriced):
a) How To Determine If An Option Is Cheap (Underpriced) Or Expensive (Overpriced) - Part 1
b) How To Determine If An Option Is Cheap (Underpriced) Or Expensive (Overpriced) - Part 2

6) The Behavior of Implied Volatility (IV) & Historical Volatility (HV) Before & After Earnings Announcement

7) Example on How Implied Volatility (IV) Affects Option�s Price Significantly

8) What To Consider When You Are Buying An Overpriced (High IV) Options?

9) Volatility Smile and Volatility Skew:
a) Part 1: Description
b) Part 2: More Understanding
c) Part 3: Why Volatility Smile and Skew Happen
d) Part 4: Implications of Volatility Smile & Volatility Skew
e) Part5: Strike Skew and Time Skew

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More Understanding About Implied Volatility (IV)

In options trading, it�s crucial that one must understand the impact of volatility on options pricing. Because it�s possible that the stock price has moved profitably, but the option�s price did not.

Options Pricing & Implied Volatility (IV)
In options pricing, it is the Implied Volatility (IV) that affects the price of an option, not Historical Volatility (HV).
IV has a huge impact on the option price. However, it is important to highlight that IV affects only the time value component of an option's price, not on the Intrinsic Value. Therefore, ATM (At-The-Money) and OTM (Out-of-The-Money) options are the ones that will be greatly affected by IV movement, as compared to ITM (In-The-Money) options. How much IV changes affect an option�s price can be estimated from its Vega.
To get data on Vega, as well as other options greeks (Delta, Gamma, Rho, Theta) for various strike prices and expiration months, we�ve discussed it before here.

How does IV influence an option�s price?
Assuming all factors remain constant:
An increase in IV will increase an option�s price (both Call and Put options).
A decrease in IV will decrease an option�s price (both Call and Put options).

The reason is because higher IV implies that a greater fluctuation in the future stock price is expected due to some reasons. And with greater expected fluctuations, there will higher chances for an option to move into your favor by expiration.
Therefore, when volatility is expected to be high (i.e. higher IV), option�s prices will relatively be more expensive.

The Effect of IV on Option�s Buyer and Seller
As higher IV causes option price to rise (assuming other things constant), an increase in IV would benefit option buyers, but will be disadvantageous for option sellers (for both Calls & Puts).
On the other hand, a decrease in IV would have a negative impact on option buyers, but will be beneficial for option sellers.

As a result:
When IV is relatively low and is expected to rise, buy options (i.e. consider options strategies to take advantage of the expected move that allow us to be an option buyer).

When IV is relatively high and is expected to drop, sell options (i.e. consider options strategies to take advantage of the expected move that allow us to be an option seller).

Implied Volatility (IV) For Various Strike Prices
IV is generally not the same for various strike prices, and also between Call & Put options.
For the same expiration month, IVs vary by strike prices.
For some options, the IV of ITM & OTM options are higher ATM options. Hence, when the IVs for various strike prices are plotted into a chart, it would take shape approximately like a U-pattern, which is by glance, it looks like a smile. As such, this is often known as �Volatility Smile�.
Other options may have higher IV for more ITM options and then it�s decreasing as it moves towards OTM, or vice versa. Such pattern is called �Volatility Skew�.
Basically, either Volatility Smile or Volatility Skew is typically used to describe the general phenomena that IVs vary by strike price.



Picture courtesy of: riskglossary.com/link/volatility_skew.htm

To understand more about Implied Volatility, go to: Understanding Implied Volatility (IV).

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Relationship between Historical Volatility (HV) and Implied Volatility (IV)

In the previous posts, we�ve discussed about the differences between Historical Volatility (HV) and Implied Volatility (IV) and the sources / websites to get such info.
In this post, we�ll talk further about the relationship between HV & IV.

What is the relationship between Historical Volatility (HV) and Implied Volatility (IV)?
At a certain point of time, IV is hardly related to HV because IV represents future expectations of stock price movement due to certain reasons, which may not be reflected in Historical Volatility (HV).
Remember that IV is a prediction of stock�s volatility for the next 30 trading days, whereas HV is a measure of stock�s volatility over the past 30 trading days.
When we�re expecting some important events will happen in the next 30 days (e.g. earnings announcement, FDA approvals, etc.), IV will be relatively high. But this may not be reflected in the �what has happened� during the past 30 days. Hence, we can�t really compare or relate IV vs. HV figures at a particular point of time.

Nevertheless, the highest, lowest & average points of HV usually might provide some benchmarks for IV. Highly volatile stocks tend to have relatively higher IV than less volatile stocks, because highly volatile stocks have higher historical volatility as compared to less volatile stocks.

For example:





Picture courtesy of: www.ivolatility.com

As can be seen in the above pictures, AAPL�s IV numbers (gold colored line) range between 24% to 54%, while its HV figures (blue colored line) also fluctuate in about the same range.
In contrast, LMT�s IV varies between 15% to 35%, whereas its HV ranges from 11% to 36%. (Before the recent sell-off starting from mid July, the IV & HV only range between 15% to 24% and 11% to 24%, respectively. During massive sell-off periods, volatilities normally increase across almost all stocks, reflecting greater overall market uncertainties).
APPL is more volatile than LMT, as reflected in the Historical Volatility figures, and consequently, AAPL�s Implied Volatilities are generally higher than LMT.

There is no standard figure to determine if IV is high or low across all stocks. Implied volatilities of a stock should be compared against its own previous IV figures, not with the other stocks.
For example, IV = 34 can be considered very high for LMT, but it is deemed quite low (average) for AAPL, when it�s compared relatively to its individual stock�s past IV data.

To understand more about Implied Volatility, go to: Understanding Implied Volatility (IV).

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How To Get Historical Volatility (HV) vs. Implied Volatility (IV) Information � Part 2

Go back to Part 1.

How To Get HV and IV Info (Cont�d)
3) optionistics.com.
This site provides some tools & data such as:

• Option Chain: It provides IV as well as Options Greeks data (Delta, Gamma, Rho, Theta, and Vega) for various strike prices and expiration months (not only near ATM options).
• Options Calculator & Probability Calculator.
• Volatility Charts.

There are 2 types of Volatility Charts provided in this site (for 1 week, 1 month, 2 months and 3 months windows):

a) Stock Price vs. Implied Volatility (IV) chart.
This chart can be found under �Tools� >>�Stock Price History� at the left bar.
However, this chart shows no Historical Volatility (HV), and the longest window period of the chart is for 3 months only.




b) Option Price vs. IV chart.
This chart can be found under �Tools� >>�Option Price History� at the left bar.
The good thing about this chart is that it can provide the Option Theoretical Price & IV chart for various strike prices. As we�ll discuss further in the future, Implied Volatility (IV) does vary by strike price.
On top of that, you can also select (from the drop-down menu) other options greeks to be plotted with Option Theoretical Price in case you�d like to analyze the trend of each greeks during the selected period of time.
To get the chart, simply type in the Option Symbol (e.g. APVJV is the symbol for AAPL Oct 130 Call).



Pictures courtesy of: optionistics.com.

I�m sure there are many other websites that provides such information for free. In case you know one/s, please feel free to chip in. I�ll compile a list for the benefit of everyone. Thanks in advance. :)

Next topics:
What�s the relationship between Historical Volatility (HV) and Implied Volatility (IV)?
How to make use of the volatility info to determine if an option is expensive (overpriced) or cheap (underpriced)?
How to benefit from volatility changes? How does volatility affect our option strategy consideration?

We�ll talk about this further in the next posts. Have a nice day! :)

To understand more about Implied Volatility, go to: Understanding Implied Volatility (IV).

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* Options Trading Basic � Part 1
* Options Trading Basic � Part 2
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How To Get Historical Volatility (HV) vs. Implied Volatility (IV) Information � Part 1

In the previous post, we discussed what volatility is and the differences between Historical Volatility (HV) and Implied Volatility (IV). Now, we�ll carry on with some websites for obtaining volatility information.

How To Get HV and IV Info
The following are the sources from which I usually find HV and IV info for FREE:

1) ivolatility.com.
This site provides some tools & data such as:

• Stock�s Historical Volatility (HV) and Implied Volatility (IV) figures (1 day lag).
• IV and Delta figures for near ATM options (No other Options Greeks info).
• Options Calculator.
  It can be found under �Analysis Service� >> �Basic Calculator� at the left bar.
• Volatility Charts.
  This chart shows Historical Volatility (HV) and Implied Volatility (IV) for 3 months, 6 months, and 1 year window (The charts are located at the right side). Advantage: What I like from the Volatility Chart in this site is that the time-scale (in terms of months) in the horizontal axis is very clear. Hence, it�s easier to make quick comparison between months.
  Disadvantage: The stock price is plotted separately from HV vs. IV. Not too straightforward for analysis & comparison.

Picture courtesy of: www.ivolatility.com.

2) My options broker: OptionsXpress.
Here are volatility related tools / info I use from this site:

• Real-time IV figures for various strike prices and expiration months (not only near ATM options).
• Options Pricer.
  This tool can be used to calculate theoretical option�s price (options calculator), as well as to show the real-time Options Greeks data (Delta, Gamma, Rho, Theta, and Vega).
• Volatility Chart.
  This chart shows Historical Volatility (HV) and Implied Volatility (IV) vs. Stock Price for 3 months, 6 months, and 1 year window.
  Advantage: HV vs. IV vs. stock price, all plotted in one chart. It�s easier for analysis & comparison (e.g. The reason why there is a drastic surge in HV is because of the price gap up / down due to earnings announcement).
  Disadvantage: The time-scale (in terms of months) in the horizontal axis is not very straightforward. Hence, it�s more difficult to make quick comparison between months.

Picture courtesy of: www.optionsxpress.com.

Note:
In case you want to find out more about OptionsXpress, I�ve previously shared my experience & knowledge about this broker in my prior post: �My Online Stock Option Brokers (Part 1)�.

Continue to Part 2 for more sources / websites.

To understand more about Implied Volatility, go to: Understanding Implied Volatility (IV).

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Historical Volatility (HV) vs. Implied Volatility (IV): Definition

WHAT IS VOLATILITY?
Volatility is a measure of risk / uncertainty of the underlying stock price of an option. It reflects the tendency of the underlying stock price of an option to fluctuate either up or down. Volatility can only suggest the magnitude to the fluctuation, not the direction of the movement of the price.

In options, there are 2 types of volatility:

1) Historical Volatility (HV), or sometimes called Statistical Volatility (SV): A measure of the fluctuations of the stock price over the past 30 trading days.
Therefore, when there is a sharp move in the stock price (up or down) during that period, the Historical Volatility (HV) number will increase drastically.
HV is obtained by calculating the standard deviation of historical daily price changes (i.e. daily returns) over the specified period.

2) Implied Volatility (IV): An estimate of the volatility of the stock price for the next 30 trading days.
Higher Implied Volatility (IV) reflects a greater expected fluctuation (in either direction) of the underlying stock price. This could be due to earnings announcement is nearing, pending for FDA approvals, or some other important event / news, which is expected to move the stock price drastically.
IV can be obtained by finding the volatility figure that makes the theoretical value of an option to be equal to the market price of the option (calculated through Option Calculator / Pricer).
(Perhaps that�s why it�s called �Implied Volatility�, because it is the volatility "implied" by the option�s market price).

Both HV and IV are usually expressed as a percentage and annualized. Due to this standardized expression, the figures can be used to compare the volatility across different stocks, regardless of the stock price.

To understand more about Implied Volatility, go to: Understanding Implied Volatility (IV).

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Option Greeks: VEGA

Vega measures the sensitivity of an option�s price to changes in Implied Volatility (IV). Vega estimates how much an option price would change when volatility changes 1%.

A change in IV will affect both Calls and Puts options the same way:
An increase in IV will increase an option�s price, while a decrease in IV would decrease an option�s price.
The reason for this is that higher volatility implies greater expected fluctuations in the stock price, which means a greater possibility for an option to move into your favor by expiration.
Since higher volatility leads to higher option price (assuming other things constant), an increase in IV would benefit option buyers, but will be detrimental for option sellers (for both Calls & Puts). Whereas a decrease in IV would have a negative impact on option buyers, but will be beneficial for option sellers.

Example:
The current price of ABC May 50 Call is $3, with Vega 0.20 and the volatility of ABC stock is 35%. If the volatility of ABC increases to 36%, the ABC May 50 Call�s price will rise to $3.20. If the volatility of ABC drops to 34%, the ABC May 50 Call�s value will drop to $2.80.

Vega and the position in the market:
* Long calls and long puts both always have positive vega.
* Short calls and short puts both always have negative vega.
* Stock has zero vega � it�s value is not affected by volatility.

Positive vega means the option price increases when volatility increases, and decreases when volatility decreases.
Negative vega means the option price decreases when volatility increases, and increases when volatility decreases.

Vega of ATM, ITM & OTM Option
The impact of volatility changes is greater for ATM options than for the ITM & OTM options.
Vega is highest for ATM options, and is gradually lower as options are ITM and OTM.
This means that the when there is a change in volatility, the value of ATM options will change the most. This makes sense because ATM options have the highest time value component, and changes in Implied Volatility would only affect the time value portion of an option�s price.
Comparing between ITM & OTM options, the impact of volatility changes is greater for OTM options than it is for ITM options.

The Impact of Time Remaining to Expiration on Vega
Assuming all other things unchanged, Vega falls when volatility drops or the option gets closer to expiration.
Vega is higher when there is more time remaining to expiration. This makes sense because options with more time remaining to expiration have larger portion of time value, and it is the time value that is affected by changes in volatility.

Other Important Characteristics of Vega:
a) Vega can move even without any changes in the underlying stock price (e.g. stocks with low Historical Volatility), because Implied Volatility (IV) is the level of expected volatility.
When Implied Volatility (IV) is high, you might want to find out what causes the high expectations. It could be due to earnings announcement is nearing, pending for FDA approvals, or some other important event / news which is expected to move the stock price drastically.
Adam's Daily Option Report has a great example in this article.

b) Vega can surge drastically due to sudden changes in the stock price, either up or down (such as a stock crash or a rapid big jump in the stock price).

To read about other Option Greeks, go to: Option Greeks.

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