40 lines
3.1 KiB
Plaintext
40 lines
3.1 KiB
Plaintext
746 Part VI: Measuring and Trading Volatility
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the order of those with insider information might come into the pit to buy options,
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but the market-makers may not sell them many, preferring to raise their offering
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price rather than sell a large quantity. If this happens a few times in a row, the options
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will have gotten very expensive as the floor broker raises his bid price repeatedly, but
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only buys a few contracts each time. Meanwhile, the market-maker keeps raising his
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offering price.
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Eventually, the floor broker concludes that the options are too expensive to
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bother with and walks away. Perhaps his client then buys stock. In any case, what has
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happened is that the options have gotten very expensive as the bids and offers were
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repeatedly raised, but not much option volume was actually traded because of the
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illiquidity of the contracts. Hence the normal warning light associated with a sudden
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increase in option volume would not be present. In this case, though, a volatility sell
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er should still be careful, because he does not want to step in to sell calls right before
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some major corporate news item is released. The clue here is that implied volatility
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literally exploded in a short period of time (one day, or actually less time), and that
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alone should be enough warning to a volatility seller.
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The point that should be taken here is that when options suddenly become very
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expensive, especially if accompanied by strong stock price movement and strong
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stock volume, there may very well be a good reason why that is happening. That rea
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son will probably become public knowledge shortly in the form of a news event. In
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fact, a major market-maker once said he believed that rrwst increases in implied
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volatility were eventually justified - that is, some corporate news item was released
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that made the stock jump. Hence, a volatility seller should avoid situations such as
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these. Any sudden increase in implied volatility should probably be viewed as a
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potential news story in the making. These situations are not what a neutral volatility
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seller wants to get into.
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On the other hand, if options have become expensive as a result of corporate
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news, then the volatility seller can feel more comfortable making a trade. Perhaps the
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company has announced poor earnings and the stock has taken a beating while
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implied volatility rose. In this situation, one can assess the information and analyze it
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clearly; he is not dealing with some hidden facts known to only a few insider traders.
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With clear analysis, one might be able to develop a volatility selling strategy that is
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prudent and potentially profitable.
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Another situation in which options become expensive in the wake of market
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action is during a bear market in the underlying. This can be true for indices, stocks,
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and futures contracts. The Crash of '87 is an extreme example, but implied volatility
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shot through the roof during the crash. Other similar sharp market collapses - such
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as October 1989, October 1997, and August-September 1998 - caused implied
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volatility to jump dramatically. In these situations, the volatility seller knows why |