I’ve read a few option books.
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A wonder wealth of knowledge there. Thanks so much for your kindness in publishing it!

Thank you very much for the most concise and simplest option intro. Highly recommended.

So far, yours is the best blog/site on basic options notes in the web that I have chanced upon.

Sunday, April 27, 2008

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).

Related Topics:
* FREE Trading Educational Resources You Should Not Miss
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Option Greeks
* Learning Candlestick Charts
* Learning Charts Patterns

2 comments:

Tony Chai said...

Hi OB :

Great of you to reinforce the importance of looking at the option's IV before taking up any position / strategy & in the consideration for the exit strategy.

Hope you're doing well in your trading.

Yours Truly,

Tony Chai
Options Trading Blog

OPTIONS TRADING BEGINNER said...

Hi Tony,

Happy to see your comment again here. :)

Hope the same for you too...

Regards,
OTB