to its value increase? Was it delta because the underlying stock rose? Or
was it vega because volatility rose? How did time decay factor in? Using a
volatility chart in conjunction with a conventional stock chart (and being
aware of time decay) tells the whole, complete, story.
Another reason historical option prices are not used in TA is the option
bid-ask spread. For most stocks, the difference between the bid and the ask
is equal to a very small percentage of the stock’s price. Because options are
highly leveraged instruments, their bid-ask width can equal a much higher
percentage of the price.
If a trader uses the last trade to graph an option’s price, it could look as if
a very large percentage move has occurred when in fact it has not. For
example, if the option trades a small contract size on the bid (0.80), then on
the offer (0.90) it would appear that the option rose 12.5 percent in value.
This large percentage move is nothing more than market noise. Using
volatility data based off the midpoint-of-the-market theoretical value
eliminates such noise.
Fundamental Analysis
Fundamental analysis can have an important role in developing
expectations for IV. Fundamental analysis is the study of economic factors
that affect the value of an asset in order to determine what it is worth. With
stocks, fundamental analysis may include studying income statements,
balance sheets, and earnings reports. When the asset being studied is IV,
there are fewer hard facts available. This is where the art of analyzing
volatility comes into play.
Essentially, the goal is to understand the psychology of the market in
relation to supply and demand for options. Where is the fear? Where is the
complacency? When are news events anticipated? How important are they?
Ultimately, the question becomes: what is the potential for movement in the
underlying? The greater the chance of stock movement, the more likely it is
that IV will rise. When unexpected news is announced, IV can rise quickly.
The determination of the fundamental relevance of surprise announcements
must be made quickly.
Unfortunately, these questions are subjective in nature. They require the
trader to apply intuition and experience on a case-by-case basis. But there