Looking at the right side of the chart, in late July, with IV at around 50
percent and realized vol at around 35 percent, and without the benefit of
knowing what the future will bring, it’s harder to make a call on how to
trade the volatility. The IV signals that the market is pricing a higher future
level of stock volatility into the options. If the market is right, gamma will
be good to have. But is the price right? If realized volatility does indeed
catch up to implied volatility—that is, if the lines converge at 50 or realized
volatility rises above IV—a trader will have a good shot at covering theta.
If it doesn’t, gamma will be very expensive in terms of theta, meaning it
will be hard to cover the daily theta by scalping gamma intraday.
The question is: why is IV so much higher than realized? If important
news is expected to be released in the near future, it may be perfectly
reasonable for the IV to be higher, even significantly higher, than the
stock’s realized volatility. One big move in the stock can produce a nice
profit, as long as theta doesn’t have time to work its mischief. But if there is
no news in the pipeline, there may be some irrational exuberance—in the
words of ex-Fed chairman Alan Greenspan—of option buyers rushing to
acquire gamma that is overvalued in terms of theta.
In fact, a lack of expectation of news could indicate a potential bearish
volatility play: sell volatility with the intent of profiting from daily theta
and a decline in IV. This type of play, however, is not for the fainthearted.
No one can predict the future. But one thing you can be sure of with this