25 lines
1.7 KiB
Plaintext
25 lines
1.7 KiB
Plaintext
IV is a common cause of time-spread failure for market makers. When i
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in the front month rises, the volatility of the back-months sometimes does
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as well. When this happens, it’s often because market makers who sold
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front-month options to retail or institutional buyers buy the back-month
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options to hedge their short-gamma risk. If the market maker buys enough
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back-month options, he or she will accumulate positive vega. But when the
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market sells the front-month volatility back to the market makers, the back
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months drop, too, because market makers no longer need the back months
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for a hedge.
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Traders should study historical implied volatility to avoid this pitfall. As
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is always the case with long vega strategies, there is a risk of a decline in
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IV. Buying long-term options with implied volatility in the lower third of
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the 12-month IV range helps improve the chances of success, since the
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volatility being bought is historically cheap.
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This can be tricky, however. If a trader looks back on a chart of IV for an
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option class and sees that over the past six months it has ranged between 20
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and 30 but nine months ago it spiked up to, say, 55, there must be a reason.
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This solitary spike could be just an anomaly. To eliminate the noise from
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volatility charts, it helps to filter the data. News stories from that time
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period and historical stock charts will usually tell the story of why volatility
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spiked. Often, it is a one-time event that led to the spike. Is it reasonable to
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include this unique situation when trying to get a feel for the typical range
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of implied volatility? Usually not. This is a judgment call that needs to be
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made on a case-by-case basis. The ultimate objective of this exercise is to
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determine: “Is volatility cheap or expensive?” |