OPTIONS TALK: Volatility Rush/Crush—Friend or Foe?
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July 21, 2006
My next two articles will focus on a very important and often misunderstood concept by the novice in the world of options trading: Volatility Rush and Volatility Crush. Part 2 of this series will follow Volatility Rush and the impact this has on an option’s premium.
Volatility Rush is a term used to describe when Implied Volatility [IV] increases during the life of a trade. To relate IV back to its greek form, we use vega.
The best way to see this in action is by looking at a chart of IV. Chart 1 is a 90-day-plus IV chart of Google (GOOG) and shows how we measure current IV relative to where it has been in the past to determine if we are in a low or high IV environment.
Chart 1 – GOOG over 90 day IV chart
Let’s now look at the impact of an IV rush and how that will influence an option’s premium. Chart 2 shows a GOOG 400 Dec06 Call option. We can see the entry price generates an initial loss of $46.59. This occurs because of the difference between the entry debit of the trade being 45.00 and the model price of 44.53. The initial IV is 37.8% and Vega is 101.1 which means that a 1% variation in IV will change the price of the option premium by approximately $101, all other things being equal.
Chart 2 – GOOG Call Risk Graph
What would happen if IV increased by 5%?
Chart 3 highlights a few key points. By increasing the IV by 5% we can see that our profit would increase from -$46.59 to $458.67, all other things being equal. This is a total increase of $505.26 and can be deduced by multiplying the vega of
101.1 by 5.
Chart 3 – GOOG Call Risk Graph
This is a great example of how an increase in IV can work in the option buyer’s favour. Checking where IV currently lies should form an integral basis to your option selection strategy. Option strategies that benefit from rising Implied Volatility include buying Calls or Puts, Bull Call Spreads and Bear Put Spreads, Straddles and Strangles, Calendar Spreads and Ratio Backspreads. These trades should be placed with IV being relatively low and rising.
As an options trader, it is imperative to look for an edge in the market. Knowing where you currently sit on the IV curve (low or high) will assist you in finding where this trading edge lies.
As the general market cliché goes, “Buy Low, Sell High”. The same applies for IV.
Make it happen,
Guy Halpin
Trading Tutors
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