IV applied to Buying Vs. Selling Option Contracts!

Question

Is low IV (Implied Volatility) good for selling or buying options?

Answer 1

It's not really "good" or "bad". Low IV simply means that the market does not expect the stock to move as much as one with higher IV.

You could think of options with low IV to be "cheap" since they have less excess cost over their "intrinsic" value, meaning what the option would pay off if it were exercised today, but that isn't always "good". It can be good if you buy the option "cheap" and the option's IV increases, meaning the options get more expensive, but that's only one factor. If you buy a "cheap" call option and the underlying price drops, that drop may reduce the value of the option more than any change in IV, and you would still have a loss.

On the other hand, options with higher IVs have larger probabilities (according to the market) of larger moves, making options like deep out-of-the-money options more likely to end up profitable.

So in general a lower IV can make options less expensive (versus equivalent options with higher IV), but it doesn't guarantee profit by any means.

Answer 2

Low IV - compared to what?

If you believe IV is low compared to HV over some time frame, it makes sense to buy low, sell high by going long vega, i.e. buying calls and/or puts.

Conversely, if you believe IV is relatively high you might want to sell options.

Answer 3

It is all relative.

Comparing IV to historical vol (HV) - also called realized volatility (RV) - is not necessarily useful for at least two reasons:

1 ) Empirically, IV tends to overestimate RV, commonly referred to as Volatility Risk Premium

2 ) IV is the only free parameter in the Black-Scholes-Merton (BSM) model. Higher IV can be a result of compensation for tail risk.

Explanation

For 1 ), a simple explanation is that market participants tend to overestimate the likelihood of a significant market crash, which results in an increased demand for options as protection against an equity portfolio. This can be exploited, as for example demonstrated in Sullivan, R., Israelov, R., Ang, I., & Tummala, H. Understanding the Volatility Risk Premium. The authors show that the returns of an investor who sells the same 5% out-of-the money put option every month, delta hedges it and holds it to expiration generated 1.5% annualized returns with a Sharpe ratio of 0.68. Compared to the S&P Sharpe Ratio of 0.32 over the same observation period (1996-2016), this is an attractive strategy.

2 ) BSM asserts that IV is constant, and returns are normal. Both assumptions are unrealistic. However, option markets correct for this with the IVOL skew (smirk, smile). You can see some interesting examples on Voladynamics Website. If you have access to Bloomberg, OVDV is your get go tool (for FX, Commodity and Equity, Indices, Futures; for CDS Options it would be OMON, for IR it is VCUB).

A less sophisticated approach of fitting IVOLs compared to voladynamcis is the SABR model. The gif below uses Julia and the formulas 2.17 onwards from Hagan et al (2002, p. 89). In case you are interested in programming, you can find the code and details about the model here. Essentially, α mainly controls the overall height, ρ (correlation) controls the skew (for set beta) and ν (vol of vol) controls the smile.

In equity, it is not uncommon to see ATM 1M IVOL to be ~20-25, whereas 80% moneyness is >70%. Looking at current IVOL at 80% moneyness in an isolated manner will tell you close to nothing about (expected) RV. For each strike and maturity there is a different implied volatility. This could be interpreted as the market’s expectation of future volatility between today and the maturity date in the scenario implied by the strike.

What can be done to figure out if current IV is an outlier

You can get all sorts of relative comparisons from the vol surface. Empirically, IV does seem to be mean reverting and as such, large deviations will usually mean you will get back to the mean.

• you can rank current IV (for several moneyness levels) in percentile of IV over some predefined period
• you can fit a vol surface and compare individual option IV against the vol surface (fitting, especially for American options is difficult because put call parity does not hold and implied forwards and dividends are difficult to get - even if you have a well-defined vol surface, outliers may in fact just be a result of stale data or indicative quotes that you cannot execute)
• you can look at risk reversal and butterfly vols (for several deltas for example 25D and 10D) to get an idea of skewness and kurtosis levels
• you can compute implied correlations from ATM IV (in FX it is common to use the Law of cosines and Volatility Triangulation for example)

If you have access to Bloomberg, you can check VCA, which displays all of the above, tickerized to run it on a chart (GP) or in historical spread analysis (HS). For example, SPX 3M IC BVOL Index DES for implied correlation SPX 3M RC BVOL Index DES for realised correlation You can use those in HS: SPX 3M IC BVOL Index SPX 3M RC BVOL Index HS

Products to consider:

• Straddles: the price of a straddle is equal the mean absolute deviation (MAD) of the stock price, as a result the Straddle Price = 0.8 * Implied Vol * √(DTE/252) * Stock Price. The 0.8 is the mean absolute deviation of the normal distribution (the proof can be found here. If you are long, the straddle becomes more valuable when the underlying market moves away from the exercise price. You also exhibit the following characteristics.
  +Gamma (desire for movement in the underlying contract)
  –Theta (the value of the position declines as time passes)
  +Vega (the value of the position increases as implied volatility rises)
  

• Risk Reversals: if skewness is particularly pronounced, it may revert back to normal

• ...

Overall, options trading is very complex, and seldom profitable if not done with great care. I recommend Sheldon Natenberg as a very good, yet very simple book about volatility strategies. The figure below is from his book and relates the aforementioned results to more structures.