Implied volatility is a major determinate of the magnitude of the extrinsic option premium. Considered together with time, these two factors act in concert to define the pricing of the time value (extrinsic value) of options.
Two characteristics of implied volatility are reproducibly reflected in option pricing: 1.The inverse relationship of price of the underlying security, and 2.The correlation of implied volatility with the rapidity of the price movement. The largest movements in implied volatility are therefore to be expected in a rapid downward price move of the underlying security.
Because vertical volatility skew results in an array of implied volatility values it is helpful to consider the generally accepted reference point. This benchmark value of implied volatility is the average of the implied volatility values for the at-the-money front month strikes in all but the last week of the options cycle.
It is always helpful to return to these basic concepts when significant movement occurs in order to be certain the conceptual relationships are maintained. Departure from the expected behavior is often an important clue to something nefarious afoot, as it was in the famous Sherlock Holmes investigation of the disappearance of the race horse, Silver Blaze, wherein the critical clue was that of the dog who didn’t bark.
Last Tuesday sell off in AAPL proves to be instructional when considered in light of the effects on implied volatility. AAPL closed Monday at $268.30 and the IV was 35%. AAPL gapped down Tuesday morning and by 1:00 PM was trading at $256.91 with option implied volatility of 40%. On the basis of Monday’s closing price and implied volatility values, this price represented a move of greater than 2 standard deviations.
IV responded as predicted by the usual relationship. The dog barked.
Bill Burton
Writer, Market Taker Mentoring LLC
thanks for the information i enjoyed reading it.
Comment by Tomasa Eubanks — September 13, 2010 @ 8:38 am