A Different Look at Implied Volatility

08/09/2011 3:30 pm EST

Focus: OPTIONS

Steve Lentz

Director of Education, OptionVue Systems, Inc.

Options educator Steve Lentz analyzes implied volatility a bit differently than most option traders, and here, he explains his method and the sound reasoning behind it.

You’ve probably heard that the VIX is a good thing to watch to determine fear in the market, but do traders use it differently in different situations? 

Our guest today is Steve Lentz; he’s here to talk about how he uses implied volatility a little bit differently than most.

Steve, first of all, the VIX, most traders have a very set way of looking at it, but you look at it a little bit differently.

We look at volatility from a different perspective. Implied volatility of the options can go up and it can stay up for a long time. 

There used to be a time when the common thinking in options was—and a lot of people still subscribe to this—that if implied volatility is at its six-month high or its 12-month high, well, it must be turning around to go the other direction.

Or if it’s at its six-month low or its 12-month low, well then, it must be turning around and going up. 

You may as well say that you’re predicting that the market itself, the underlying market, is going to switch directions. And if you are really that good at predicting that, there are other ways to make better money trading the underlying itself.

Instead, what we do is look at the trendiness of the statistical volatility of the underlying asset itself. If the underlying asset has a volatility level that is drifting, say, upward, typically it means that the market is going down. 

But if it’s drifting upward, in terms of selling premium non-directionally, we don’t want to do that, so we pay more attention to the trendiness of the underlying asset itself.

See video: Option Volatility Made Simple

So that’s where you recommend starting is with the underlying asset and then going to the option and trying to figure to the strategy?

Yes…now implied volatility is important, but in terms of selling option premium, you have to pay attention to the volatility of the underlying asset itself. Understand that every bit as much—or more—as implied volatility.

Do your strategies change when you have a period like we had in early summer time where volatility is kind of just flat; it’s relatively low compared to what it has been maybe a year ago. Do strategies change, or do your thoughts change about the market?

If the volatility in the underlying market changes, you definitely have to adjust your strategies. If the underlying market gets more volatile, typically that means that it’s topping out or getting ready to enter a bear market; you better watch out.

For example, even going into the “flash crash,” May 2010, going into that, the market was rising and the volatility of the market got a little bit more. Even though it was rising, the average bars day by day over the course of a few weeks did expand, kind of almost as a bit of tremor in the markets before the big earthquake hit with that flash crash.

Now the crash of 2008, same thing, weeks beforehand the market was rising, volatility expanded even as the market was rising and getting ready to top out. That was a signal that maybe something was up. 

Someone paying attention to the volatility level of the underlying market would have been tipped off that something was up.

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