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Chapter 3 Ways To Interpret Volatility

Volatility Crush

If implied volatility is high because of an impending event, then it will decline after the event, since the uncertainty of the event is removed. This rapid deflation of implied volatility is referred to as a volatility crush.

Generally, we observer that implied volatility in options tends to pick up prior to the company’s result announcement and decreases significantly immediately after the announcement.

Whether the results turn out good or bad, new information is available to the market participants that allow the traders to re-value the stock. Large fund houses that have a position in the stock tend to buy put options before the results in order to hedge their positions. They also tend to close out their hedge position just after the result once the uncertainty is eliminated, resulting in a drop in volatility. Unless the company announces something major or the results sway drastically away from expectation, the volatility in the stock tends to decrease.

Thus, we observe novice traders losing money by trading on the result day even after getting the direction correct due to factors of implied volatility. The best way to play the volatility crush is to create option strategies that tend to benefit from a decline in volatility, for instance short straddle - which are covered below under applications of volatility.

Volatility Surge

It is the exact opposite of a volatility crush. It happens due to unforeseen events by the market participants. Panic due to such events can cause huge spike in volatility, which could even turn your losing position into a winning position. Such a case was observed on August 24, 2015 when markets tanked from 8,300 to 7,809, a crack of nearly 6%. It was the biggest fall in the markets after the 2008 crises and the 4th biggest in the history of the Indian markets.

Instrument Symbol Expiry Strike Option Open High Low Close Settle
OPTIDX NIFTY 27-Aug-15 7800 CE 281.55 281.55 111.85 122.9 122.9
OPTIDX NIFTY 27-Aug-15 7850 CE 115 120 86 97.9 97.9
OPTIDX NIFTY 27-Aug-15 7900 CE 225 225 55.45 73.6 73.6
OPTIDX NIFTY 27-Aug-15 7950 CE 118.55 160.95 30 53.85 53.85
OPTIDX NIFTY 27-Aug-15 8000 CE 102.1 120.35 34.65 40.75 40.75
OPTIDX NIFTY 27-Aug-15 8050 CE 66.55 100 20 29.7 29.7
OPTIDX NIFTY 27-Aug-15 8100 CE 75.6 75.6 16.35 21.4 21.4
OPTIDX NIFTY 27-Aug-15 8150 CE 46.05 46.05 12.45 15.6 15.6
OPTIDX NIFTY 27-Aug-15 8200 CE 41.3 41.3 9.25 11.9 11.9
OPTIDX NIFTY 27-Aug-15 8250 CE 26.45 26.5 6.7 10.1 10.1
OPTIDX NIFTY 27-Aug-15 8300 CE 8 14.6 3.7 7.4 7.4
OPTIDX NIFTY 27-Aug-15 8350 CE 1.5 15 1.5 6.9 6.9
OPTIDX NIFTY 27-Aug-15 8400 CE 3 9.8 2.2 5.8 5.8
OPTIDX NIFTY 27-Aug-15 8450 CE 1.85 7.8 1.85 5.3 5.3
OPTIDX NIFTY 27-Aug-15 8500 CE 3.05 6.5 2.05 4.4 4.4
OPTIDX NIFTY 27-Aug-15 8550 CE 1.9 4.6 1.75 4.1 4.1
OPTIDX NIFTY 27-Aug-15 8600 CE 1.9 3.5 1.55 3.1 3.1
OPTIDX NIFTY 27-Aug-15 8650 CE 0.15 3.5 0.15 3.25 3.25
OPTIDX NIFTY 27-Aug-15 8700 CE 0.95 2.8 0.95 2.55 2.55
OPTIDX NIFTY 27-Aug-15 8750 CE 0.1 3.5 0.1 2.85 2.85
OPTIDX NIFTY 27-Aug-15 8800 CE 1 2.4 0.8 2.05 2.05

Generally, it is observed that call option premiums tend to fall when there is a crash in the markets. But on August 24, 2015, something slightly different was observed. Call options that were out of the money witnessed a surge in option premiums to the tune of 50 to 100%.

This phenomenon can be explained due to two factors of option greeks:

Delta: Delta is the amount an option price is expected to move based on one point change in the underlying.

Vega:  Vega is the amount option prices will change, for a corresponding one-point change in implied volatility.

Option Greek Impact of crash on OTM Call options
Delta
Vega

So when markets cracked on August 24, 2015 call options that were out of the money i.e. strikes 8350 and above that already had a low value of delta witnessed a further decrease in value of delta as markets moved from 8300 to 7809.

While India VIX, a measure of volatility of the entire market, increased to 28% from 17% surging nearly 65% at the close. This unexpected surge in volatility caused the vega component of the out of the money call options to increase sharply.

The combination of a decline in an impact of delta and a surge in volatility caused the vega component to overshadow delta resulting in an unusual price rise in these out of the money call options

Open Interest and Implied Volatility Interpretation

Option Type O.I Implied Volatility Interpretation
Call Increasing Increasing Call Buying
Call Increasing Decreasing Call Writing
Put Increasing Increasing Put Buying
Put Increasing Decreasing Put Writing
Call Decreasing Increasing Short Covering in Call
Call Decreasing Decreasing Long Unwinding in calls
Put Decreasing Increasing Short Covering in Put
Put Decreasing Decreasing Long Unwinding in Put

VIX

VIX stands for volatility index. These volatility indices are measure of market expectation of volatility over a short duration. The first volatility index was VIX introduced at Chicago Board Option Exchange (CBOE).

India VIX

In India, NSE has constructed a volatility index called India VIX. India VIX indicates the investor’s perception of the market’s volatility in the near term. The value is calculated based on the best bid- ask prices of Nifty option contracts. It is an annualized percent figure that estimates the market volatility over the next 30 day time period. The same computation methodology as CBOE is made use of with desired change to reflect the Nifty options order book. Constant fluctuations are witnessed in India Vix values, a high value would imply that market participants expect a significant movement in the price of Nifty while a low value would imply that markets are expected to trade range bound in the near term. Historical data suggest that India VIX and Nifty have shown an inverse relation.

In India future contracts of India VIX are traded. The product allows the trader to

a) Hedge an equity portfolio

b) Take a position based on expected directional movement in volatility

c) Made use of as diversification product in a portfolio

Fear Index

The high level of VIX attracts media attention when the overall stock market is under pressure. Usually the terms fear and greed index are associated with it. The reason for this being the type of option trading that occurs during weakness in the market. When traders are concerned about the direction in the market, they tend to protect their overall position. One common strategy made use of in times of panic is to purchase put options of the Nifty Index. The aggressive purchase of the Nifty put option results in a surge in implied volatility. Hence India VIX, which measures the implied volatility of the Nifty index options, tends to rise when the markets fall and is seen to have an inverse relationship with Nifty.

Volatility Skew

Volatility skew is a result of different implied volatilities for different strike prices of a call or put option. Volatility skew further illustrates that implied volatility depends only on the option premium, not on the volatility of the underlying asset, since that does not change with either different strike prices or option type.

How the volatility skew changes with different strike prices depends on the type of skew, which is influenced by the supply and demand for the different options.

The concept of volatility skew came after the Black Monday 1987 crash in the US markets, before which volatility skew hardly existed. What this means is that if we looked at an option chain, we would see puts and calls equidistant from the current stock price priced nearly the same.

I.e. If Nifty is trading at 10700 an 11000CE would be priced similar to 10300 PE.

After the crash traders soon realize that it was riskier to short put options compared to shorting call options as markets tend to correct with more swiftness than move up. Traders, therefore, started charging a higher premium in order to write put options from the put buyers.

Over the years, as demand for out of the money put options surged in order to hedge the portfolio from frequent market crashes and as put writers charged a premium in order to balance the risk reward, a volatility skew was witnessed resulting in a higher premium for out of the money put options compared to call options.

Reverse Skew/Normal Skew: Is exhibited when out-of-the-money puts are more expensive compared to out of the money call options.

The popular explanation for the manifestation of the reverse volatility skew is that investors are generally worried about market crashes and buy puts for protection. In the Indian markets as well we generally witness a reverse skew as can be seen from the above Nifty option chain.

Nifty 11000 CE is currently trading at Rs 3.40 having a I.V of 8.25%, while Nifty 10300 PE is trading at Rs 12.35 having a I.V of 15.57%; both the option are trading ~400 points from the current market price of 10684.

Forward Skew: Although we normally find puts more expensive than calls, there are instances where the skew reverses as trader’s price calls more expensive than puts. Forward skew is generally witnessed in the commodity market as we often see a surge in commodity prices due to weather and supply demand disruption and as commodities tend to have a floor price. Due to the perceived limited risk, traders are often seen buying more out of the money calls then out of the money put options.

Smiling Skew: A smiling skew is witnessed when there is heavy demand for out of the money options, which result in a surge in implied volatility, which in turn results in out of the money option prices costing more than at the money. This is generally observed before major events such as Election result outcome, Brexit vote etc. where the traders expect heavy volatile in the underlying security without having a specific view on the direction.

Flat Skew means that there is no skew and implied volatility is the same for all strike prices; however, this is hardly witnessed nowadays.

Options with the same strike prices but with different expiration months also exhibit a skew, with the far months generally showing a higher implied volatility than the near months, reflecting a greater demand for far-term options over those with later expirations.

Vega

Vega is one of the key option greeks, it is measure of the impact of changes in the implied volatility on the option price. Vega measures the change in the price of the option for a change in the securities implied volatility.

Higher the implied volatility of the option, higher is the cost associated with it. Thus, when implied volatility surges, the price of the option also tends to go higher and similarly, when volatility drops, the price of the option will also fall.

Example

Reliance Communication is currently trading at Rs 34 and a JAN35 call option is selling for Rs 2.90. Vega for the option is 0.04

The current implied volatility for the JAN35 call option is 108%. If the implied volatility increases by 4%, then the price of the option should rise to 2.90+0.04*4= Rs 3.06

However, in case the volatility falls down by 10% to 98%, then the option price would drop top to 2.9-(0.04*10) = Rs 2.5

As seen in the above example, despite of no change in stock price, option price changed independently on account of a change in implied volatility, measured by Vega.

Volatility is always expressed as a positive number for both for call and put options. A put's option price will increase as implied volatility increases in the same manner as a call options price.

Form this example we clearly see that a surge in volatility tends to benefit the buyer of the option and a decline in volatility benefits the seller, provided the rest of the factors remain constant.

Impact of time and strike price on Vega

Option premium is composed of two parts time value and intrinsic value. Intrinsic value is a measure of how much the option is in the money, while the time value is equal to the option premium minus the intrinsic value. Thus, time value depends on the probability that the option will go out of the money or stay in the money by expiration. Volatility only affects the time value of an option. Therefore, vega, as a measure of volatility, is greatest when the time value of the option is greatest and least when time value component is small. Since time value is greatest when the option is at the money that is also when volatility will have the highest effect on the option price. And just as time value diminishes as an option moves further out of the money or into the money, so goes vega.

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