Today, during one of my option mentoring sessions an options mentoring student asked me about going long or short. Specifically, we were look at Netflix. He pointed out that the stock was at a 52 week low IV, and near its two year low implied volatility:
He explained that he thought the stock was going to rally. He wanted to buy calls (a smart move when IV is low), his only fear was theta. While he thought vol would go up, he was worried that the stock was going slowly to rally, but worried that theta over the next week might kill profit from slow movement. That was when I dug in:
I asked him where he thought the stock and IV might go and under what time frame. He said he didn’t know about IV, but he thought the stock was going to be moving over the next week or so. That is when I explained to him that if in fact he thought IV was near a bottom, he probably might see IV go up, without IV actually increasing. This is a breakdown of the greeks of the calls, and where they traded today:
Most traders do not know this buy there are actually 2 ways for IV to go up.
1. Flow increases IV (most people do know this one): In a short period of time, paper begins to buy up options, increasing demand for the options. The increase in demand for option causes the price of the call or put to rise. Voila: IV goes up. A quick example using the NFLX calls:
A customer tries to buy the 1000 NFLX calls 245 calls for 11.90, an IV of 37.40. He gets filled on 100, then bids 12.00, gets filled on a hundred and so on. By the time the customer is doing buying the calls he or she has paid 12.20. The mid-price going out now $12.20 an increase of .30, which also happens to be how much VEGA these options have. Thus, the IV of the 245 calls which was 37.40 is now 38.40
2. Time stands still (this is the one most people do not understand): Over a period of days, an option does not gain value, but an option does not lose value. Because the options have the same amount of premium, but a shorter amount of time to expire the options IV creeps up over a few days. A quick example using the NFLX 245 calls:
A customer buys 100 NFLX 245 calls for 11.90 with the stock around 245.5 (an IV of 37.40). One day passes; the option is still trading 11.90, the next day, the same. And so on. 4 days later, the option is still quoting 11.90 with the stock trading 245.50. At the beginning of the 6 day period our option had about .15 of theta and .30 vega, as each day passed the .15 the option DIDN'T decay was converted into the options IV. We calculate the daily increase in IV by dividing the .15 of theta by the .30 of vega. Thus the IV moves like this:
Day 1: 37.40+ (.15/.30)=37.90
Day 2: 37.90+ (.15/30)=38.40
Day 3: 38.40+ (.15/.30)=38.90
Day 4: 38.90+ (.15/.30)=39.40
As you can see, even though price didn't change the IV is now near 40%. This is kind of a back door way IV can increase, and actually is more often how IV increases. This is often how IV goes up into earnings announcements, FDA announcements, court cases, etc (although sometimes it ends up being a combo of number 1 and number 2). This is one of the best ways to trade and can be quite profitable, traders are always trying to find an 'edge' one way to find this edge is to own options that don't decay. We used to call this 'free gamma' on the floor. Theta isn't theta if the option doesn't decay.
One last thing I would point out is that I think there are some major plays in the May VIX contract for those that think VIX can stay above 16.75%. If you are interested in signing up for Trading ETF's in a Volatile Market you can do so here.
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Graphs from LiveVolPro
