“May you live in interesting times” is an ancient Chinese curse. The fact that the last few weeks have seen neck snapping and wild changes in volatility, I think we qualify for living in what these philosophers would consider to be interesting times.
For those who are unfamiliar with the impact of volatility on option trades, suffice it to say that the current market contains unique challenges. As I write, the volatility environment has experienced remarkable volatility. While the concept of the volatility of the volatility may seem arcane, it has huge impact on the behavior of option positions.
Remember that option premium, while quoted as a single bid/ask spread, in reality consists of the sum of the extrinsic and intrinsic premiums. While the intrinsic premium may vary wildly in such markets as we currently are experiencing, it is a straightforward and transparent calculation depending solely on the current market price of the underlying and the strike price under consideration.
The extrinsic premium is not so straightforward and is impacted by several factors, the most important of which are the time to expiration and the IV. The time to expiration is clearly defined by anyone with a calendar, or perhaps a stopwatch currently, and represents another transparent variable.
The situation is much more interesting in the world of IV. This is where current unprecedented directional movements impact option prices most dramatically. The situation is rendered even more complex by the fact that the IV changes are occurring in both directions; it is not simply a trending volatility environment. The volatility of the volatility has increased dramatically.
Traders must be cautious when establishing new positions and monitor the vega of the position assiduously. In many cases, structured positions such as vertical spreads are indicated in order to reduce vega exposure.