When it comes to options, I often refer to them as a 3-D product for two components, but they also have implied volatility, also known simply as the IV.
The two components can be defined by their charts. Any chart of upper studies is two-dimensional, showing both time on the horizontal axis as well as the price of the underlying on the vertical axis. Lower studies also have the horizontal time component, but instead of the price action, there could be any other variable plotted on the vertical axis, with the most common one for the lower studies being volume.
Many novice traders approach their option trading unsuccessfully due to their sole focus on a single dimension: Price. With options, the price could move in the anticipated direction and the option premium could lose value due to time (second dimension) decay, due to change in the I.V. (the third dimension), or due to the combination of both time and I.V.
Hence, a trader at any given time should be aware of the fact that options, when purchased, are a decaying asset and that time is working against the premium buyer.
Selling Premium
However, when the premium is sold, then the option trader is a seller and time decay works in his or her favor. Time decay is inevitable regardless of what side of the trade we take. One of the ways to decrease the impact of time decay when buying options is to purchase a further-away month, perhaps two or three months out, depending on your trading plan.
For a directional swing option trader who intends to hold the position for less than a week, the scenario of purchasing either two or three months out would be correct. For the longer-term trader, LEAPS (Long-term Equity Anticipation Securities) are the best choice. LEAPS are American-style options with expiration up to three years in the future.
Implied Volatility
On the other hand, I.V. is much more difficult to deal with. We as options traders have virtually no control over it. I.V. is manipulated by the market makers. When I.V. is high, then the premium of the underlying tends to be overpriced, and vice versa. Low I.V. equals undervalued premium.
In this article, I will give an example of an almost ideal situation in which the underlying's I.V. is at its lowest annual level. For education purposes only, I will name the underlying since the process of verifying the facts could easily be done by any reader on any other underlying. The exact place on the Web where the information can be found is www.cboe.com (Chicago Board Options Exchange).
The fifth tab from the left (Trading Tools) has the Volatility Optimizer selection under which the very first choice should be selected– the IV Index. It is a free service that is powered by the IVolatilty Web site, for which users are required to have a log in. By showing the readers this avenue of using the CBOE Web site, a log in step is eliminated.
Let's move on to the exact example that I had in mind: The underlying with the lowest current I.V. As of the writing of this article, the I.V. of the exchange traded fund (ETF) that tracks the financials (XLF) is at its lowest levels. XLF's I.V. Index means both calls and puts have an I.V. in the range of 130%, being the 52-week high, and 34%, the 52-week low. The exact current I.V. as of 08-04-2009 was 35.67%.
To option traders, the fact that the underlying's I.V. is at its lowest levels for the year means that they could be buyers of premium, either calls or puts, depending on their directional bias. Once again, I am pointing this out to illustrate how to utilize the I.V. reading, and I am not suggesting the buying of anything, calls or puts.
For those more visual, I am taking a snapshot of the same info as given by the CBOE, but this time from the IVolatility Web site. Again, the line that contains the most essential info that pertains to my point is the very last row of the I.V. table. The chart below the table plots the same mathematical numbers visually. Observe that I have again, below the chart, recaptured the last row of the IV table showing the IV mean data.
Click to Enlarge
The figure above is also a two-dimensional figure. It has a horizontal axis, which represents time. Each grid square stands for one month. The vertical axis isn't price related, but it is a percentage of two types of volatilities. The black line represents the statistical or historical volatility.
The I.V is the green line and also the representation of the market makers' expectations the underlying movement in terms percentages regardless of the direction. As it can be observed from the XLF example, both lines were "sitting" on each other in the recent past. This means that the I.V. is low and that the option premium for calls or puts isn't overpriced. In fact, it is undervalued.
A word of caution: Be constantly aware of the I.V. for products that you are trading options on and have a green day!
By Josip Causic of OnlineTradingAcademy.com
