I have a concept for you that might define your success as an options trader. Here it is:
At any given moment, an option’s price is determined by the market’s belief about the likelihood of that option expiring in the money, and by how much.
Now some of you are probably saying, “Wait. That’s it? Isn’t that, like, just the definition of delta?”
Yes, that’s it. And yes, it is the definition of delta–or at least a definition of delta. But this concept doesn’t just explain Delta. It explains all of options. It explains Theta, and Vega, and Gamma….and Vanna, and Vomma, and Charm. Those greeks and the math behind them don’t dictate options prices. They simply quantify why options prices behave the way they do.
Traders often get so enamored of the technicalities of trading that they forget the fundamental aspect of what we’re doing. Don’t misunderstand me. The technicalities are important, and you need to learn them. But always remember at a more basic level what it is that we’re doing: We’re buying and selling contracts that give the buyer of the contract the right, but not the obligation, to buy a certain number of shares of stock (or, for index options, the cash value of a certain number of “shares” of the index) at a certain price at a certain date in the future. The value of those contracts is determined entirely by the likelihood of the option finishing in the money, and by how much.
This brings us to the title of this post:
Velocity Matters!
You don’t need any elaborate greeks formula to understand this. Just think about it intuitively.
The basic pricing models for options assume a symmetrical bell curve of probabilities. They don’t use technical analysis. The models assume that the underlying is just as likely to move up as it is to move down. They also assume that the probable range of the underlying’s excursion can be derived from the underlying’s recent behavior. In other words, an underlying that has been volatile is expected to continue being volatile, and an underlying that has been lethargic is expected to remain lethargic. A volatile underlying will have a broader mathematical distribution of potential prices, making it relatively more likely that an out-of-the-money option will finish in the money. That, in turn, makes that option more expensive.
Okay, fine. But why am I making such a big deal about this? Because this fundamental characteristic is what distinguishes options from stocks. And requires you to trade options differently than stocks.
Changes in velocity change the price of options. This can work for you, but it can also work against you in some surprising ways. Here are a few important examples. You may be able to think of others.
1. Try to enter net long options during a period of calm when anticipating an explosive move
Many savvy stock traders try to enter new positions during periods of declining volatility. Doing so lets them keep their stops tight. It also maximizes the time value of their risk capital because it increases the chance that they are either stopped out quickly or catch a significant move.
Those reasons work for options traders, too, but there is an even more important reason for us. During periods of volatility in the underlying, options prices can become inflated purely because the elevated volatility in the underlying increases IV in the option. If you buy an unhedged long option during this chop, you may find that even a directional move in your favor doesn’t make you money because the option begins to bleed IV.
This is especially important with in underlyings with thin markets or wide spreads. For example, I once bought an options position in $AMZN (pre-split) during a choppy moment. The price action calmed down a few minutes later and stabilized right where I had entered….My position lost $5/contract! That’s an extreme example, but these sorts of unforced errors can really hurt you, especially if you’ve also made the mistake of being over leveraged.
2. Try to enter net short positions after an explosive move when anticipating a retracement or consolidation
This principal is the inverse of the first one. If you are a net seller of options, it behooves you to sell those options when their value is inflated. That inflation can occur as a result of a directional move, but it can also occur as a result of aimless chop.
3. Avoid using options to trade breakout strategies
I don’t like breakout strategies. And I used to be a breakout trader. Breakout strategies almost always require you to use wider, or fuzzier, stops than alternative approaches. I would rather have a tighter, more concrete stop that gets hit more often than have bigger risk that is more difficult to control.
This is even truer for options. Why? Because the moment of a breakout is often explosive. It is also the moment when other options buyers all collectively agree that long out-of-the-money options might be a good play. That combination of volatility and demand means that a breakout trader is often buying options as their value is inflating. If you get stopped out, you are likely to use not only the delta to your stop but also the IV that will quickly get sucked back out of the position.
4. Avoid buying unhedged options around known market-moving events
Most options traders know this one, but I’m putting it here just in case. Be very careful buying options, particularly unhedged long options, coming into known market-moving events, like earnings or a Fed meeting. The price of those options is juiced up by inflated IV, and unless you really know what you’re doing, you can get skinned. This play can work, but it’s for experts only.
5. Adjust your positions into strength
I’ve probably saved the most important piece of advice for last. If you have a an options position that’s working, don’t wait to adjust it until it’s no longer working. Adjust into strength! That means, close it, roll it, hedge it, whatever while the position is still moving in your favor.
With options, if you think price may still continue in your favor, you can hedge gradually so that you don’t nullify your directional bias right away, but it’s a good ideal to start the process when you can, not when you have to.
The reason is the same as with the other principles we’ve already discussed. A big move in your favor–particularly a quick or fluid one move–has a tendency to inflate IV. Why? Because that quick acceleration toward the money has exponentially increased the mathematical likelihood of that option expiring in the money. If the underlying paused for a breather, that inflated IV will get sucked out. If you wait too long to hedge, you will often find that you need the underlying to make another leg up just to get back to the price you could have gotten if you’d hedged during the initial move.
I won’t belabor the point. You can probably think of more examples of how velocity matters in options trading. If you have comments or questions, post them below!
Thanks for the post! What is the best way to judge whether IV is inflated or not? Is there one specific metric for comparing, or is it simply relative to recent moves; and what timeframe is most important for judging IV? thanks in advance.
Great question. IMO assessing and reacting to IV is more art than science. It’s worth noting that unless you’re taking big, unhedged positions [10.31 EDIT TO COMPLETE UNFINISHED THOUGHT: …you don’t need to get too wrapped up in IV. The most important thing is to understand it enough, and keep and eye on it enough to make sure you don’t get too offsides. There’s always more edge to be had, just don’t let it take too much of your focus unless you actually want to “trade volatility.”] I know of three main ways to do it, roughly in order of complexity/precision:
1. Eyeball it. Look at event calendars and stock charts and ATR (average true range) data. IVs tend to rise like a tide into major events (FOMC, earnings, etc.), with that tide rising highest in near-dated expiries. Also, if the underlying has just had a violent move down or some whipping action with bigger-than-average ATR, IV is probably elevated. Obviously, this approach isn’t very precise, but it’s quick and intuitive and better than nothing.
2. Use IV Rank and IV Percentile. These metrics are available in most platforms. Most of them are calculated based on daily closing IV for a hypothetical 30-day option. The statistics evaluate how high or low today’s IV is relative to the range for that 30-day option over a given period of time–most often 52 weeks. So 52-week IV Rank will tell you, on a scale of 0-100, where in the 52-week range today’s IV falls. IV Percentile will then tell you, again on a scale of 0-100, what percentage of the prior 52-week period IV spent below it’s current level. So let’s say you have an underlying whose 52-week IV range is 20-40. Today’s IV is 30. The IV Rank will be 50 because IV is right in the middle of the range. But that only tells you so much. What if IV Percentile is 80? That would suggest that even though today’s IV of 30 is in the middle of the absolute range for the year, it’s actually pretty high because IV spent 80% of the prior year somewhere below 30. This is as keyed into to IV as most options traders get.
3. You can look at line charts comparing IV and HV for a given period. The most common chart is IV30 (30-day IV) against HV20 (20-day IV). These charts actually measure a fairly similar period because IV is calculated on a calendar-day basis, while HV is calculated on a trading-day basis. Looking at this chart will tell you everything that the IV Rank and IV Percentile statistics do because you can look at the IV line and see where we are in the absolute range and roughly how much of the prior period was spent above or below that level. The advantage of these charts is that they let you also see whether IV is corresponding to actual or “realized” volatility in the underlying (i.e. historical volatility or HV) or if it seems to be inflated or deflated for some other reason. Some people also like to annotated trends and do other TA on these charts, but that’s another subject and an approach I don’t necessarily endorse.
4. So far, the three prior ways of tracking volatility look at some fixed and somewhat arbitrary average of volatility (usually IV30) If you want to get more precise that than, you can look at charts or graphs of volatility skew and term structure, which let you compare at-the-money volatility across expiries, or volatility for every strike within each expiry. By plotting historical data, you can then look at how term structure and skew are moving through time to come to your own view of whether the volatility for a certain expiry or strike is relatively high or low. This is the most powerful way of looking at volatility, but it can also get pretty complicated. A topic for another time. There’s lots of great material on this online and in books.
Does that make sense? If not, keep asking questions!
Great answer !