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I would love to enter a few options trades but have learned (the hard way) that moves from high to low IV can mess the returns even when calling the right direction of the move. This is explained in more detail here

I want to be able to estimate the extent of the IV crush I'm up against when buying options. I'm looking at three things:

  1. IV of an at-the-money option as it stood on Jan 15th of this year. I assume this is the baseline IV that the stock will trend to as the dust settles on the current market. I'm buying LEAPs so this makes sense as a baseline IV the option with this expiry will revert to (market is not going to stay volatile for 18 months).

  2. IV of an at-the-money option as it stands TODAY. This is the IV at which I'm buying and is the upper limit from which the IV crush will be launched downwards.

  3. Vega of the option I'm buying.

My understanding is that vega will tell me how much my option price will change per 1% change in IV. My question now is, what does "1% change in IV" means. Is it an absolute 1% change, or a 1% change from the start point? In numbers:

  1. 25% (IV expected to settle at)
  2. 45% (IV as I bought it today)
  3. 0.3

Is my IV crush in the ballpark of?

a. (45-25)*(0.3) == $6

or

b. ((45-25)/45)*(0.3) == $13.32

The option I bought cost me $13.6, so I'm assuming it's (a), but really there's so much craziness going on in the markets right now, it's testing the limits of my understanding, so would really appreciate any help from the community on this one!

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  • Not certain about the rest, but vega is in terms of absolute change, not relative.
    – D Stanley
    Mar 31, 2020 at 20:20

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My understanding is that vega will tell me how much my option price will change per 1% change in IV. My question now is, what does "1% change in IV" means. Is it an absolute 1% change, or a 1% change from the start point?

IV change is absolute. If it expands from .20 to .21 then it has increased by 1%

Implied volatility is very high now so trading from the long side is much harder (it's a plus for sellers of premium). With IV crush, you have to be more right in order to get anywhere.

(paraphrased) I want to be able to estimate the extent of the IV crush I'm up against when buying options. I'm looking at ... IV of an ATM options as it stood on Jan 15th of this year (baseline) and the IV the option will revert to (market is not going to stay volatile for 18 months).... and a vega calculation example.

I think that you're missing the big picture by possibly getting lost in the vega details. Your analysis assumes that all other pricing variables are constant (they're not). Underlying price will change and so will theta as time passes.

IMO, a simpler approach is to plug all of today's variables into a pricing model to get your baseline. Now change the other ones as you see fit. If you leave everything status quo and just vary IV then you get your crush answer. If you want to project what your LEAP will be X days down the road at price Y with a lower IV of Z then you'll get a new price and you can compare it to your baseline.

Plan B is to use software that graphs this. A competent program will allow you to select all variables and see the graph on any date of your choosing. Most web site programs just depict current status and expiration status.

As an example of my big picture (3 random data points):

XYZ is $100 with an IV of .50

1/15/21 $100 call is $18.10

(a) 10 seconds from now, IV contracts to .40
The call is now worth $14.60 for a crush of $3.50

(b) Price unchanged but that IV contraction occurs 3 months from now rather than in 10 seconds. Premium is now $12.10 ($2.50 of time decay).

(c) It's 3 months from now, IV has contracted to .40 and price has risen to $105. The call is worth $15.10. You've lost $3 despite achieving a $5 gain in the underlying.

It's just my personal bent but I think that more complex strategies are indicated here. Sell expensive premium to offset the the cost of expensive premium. What that involves depends on your expectation (hope?) for the underlying, your profit objectives and your risk tolerance. Don't let me dissuade you from trading because if you have good timing and selection then you can do anything that you please. If not, paying expensive premium to be long an option is a ball and chain around your ankle.

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  • Bob thanks a ton! Always answering both the question I asked and showing me why I was asking the wrong question :) I spent some time yesterday integrating a basic Black Scholes formula in my models. The numbers are slightly off from what I'm seeing in the market, but only slightly so it's more than enough to give me the ballpark sense I needed.
    – David Karam
    Apr 2, 2020 at 9:27
  • My intention with these LEAPS is placing some small "wild bets" on big companies that have gone 60-70% down like Airbus, MGM, and AIG. It's one of the small assymetical "bets on recovery" I'm trading where the recovery upside overshadows the option premium. This is only a small part of my portfolio, I'm still mostly just long total market equity but thought a small undiversified leveraged play would be a nice addition in a small dose.
    – David Karam
    Apr 2, 2020 at 9:32
  • Are there perhaps other strategies you'd recommend for doing such leveraged long term recovery bets?
    – David Karam
    Apr 2, 2020 at 9:47
  • @David Karam - In the current high IV environment, B/A spreads have widened dramatically. Use the midpoint for any calculations. Also use real time quotes because closing quotes are usually worthless, even more so with low liquidity options that trade by appointment (the last option trade occurred prior to the close and therefore loses price alignment with the underlying). Option skew may also be a factor in causing your option model numbers to be slightly off from what you're seeing in the market. These details are fine points but not significant in a blunt force calc :->)
    – Bob Baerker
    Apr 2, 2020 at 12:56
  • Given that you are looking for a leveraged bet based on a large upside recovery, I'm going to retract my suggestion to consider other strategies. I have an issue with overpaying for options. Strategies like vertical and diagonal spreads would negate much of the IV crush but they would also limit your upside, removing much of the leveraged play. Just curious but are any of these plays on stocks that you currently own or are these other issues?
    – Bob Baerker
    Apr 2, 2020 at 13:03

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