Option Prices | Why Do They Fluctuate?
Sep 9, 2015
Following on the theme of turbulent markets, a recent episode of Market Measures took a second look at option prices through periods of increased volatility in equity markets.
During the show, Tom Sosnoff and Tony Battista reiterate the ongoing tastytrade message that sudden down moves in the markets can often present juicy opportunities for initiating short premium positions.
The hosts of Market Measures kick off the show by highlighting a chart of the VIX over the past year. As you can see below, the VIX is characterized by noticeable expansions and contractions in implied volatility:
As shown in previous research presented on tastytrade, implied volatility is mean reverting. Because option prices are directly reflective of implied volatility, that means prices exhibit the same characteristics as implied volatility.
The question Tom and Tony seek to answer is why this observable pattern occurs.
They break down the typical option trading environments into two categories to help illustrate why option prices mean revert:
Low IV: When the market is quiet (small down days, upward drift), traders are more complacent and see less need for insurance.
Result: Less volume on the buy side and consequently lower option prices.
High IV: As market uncertainty increases (larger intraday moves, market-moving catalysts), traders start buying more options to hedge their positions or establish new directional risk positions.
Result: Increased uncertainty leads to increased volume on the buy side and higher options prices.
It is at this juncture that the duration of the uncertainty in the market becomes paramount to the premium trading equation. As seen on previous episodes of Market Measures and other tastytrade programming, these periods have generally been brief, especially since 2008.
Assuming that trend continues, the opportunity to add short premium positions can indeed be attractive with broader markets selling off. The graphic below depicts the process by which markets begin to stabilize and how implied volatility deflates as more option sellers enter the market.
To close out the episode, Tom and Tony present an excellent example of this phenomenon during the most recent period of volatility during the last week of August.
In this example, the Market Measures team examined the value of the SPY versus the VIX and the price of the 95% out-of-the-money (OTM) put in the SPY from August 21st through August 26th.
This analysis starkly highlights how the September 1575 put price in the SPY inflated and then quickly deflated as the market went through its process of correction and rebound.
This phenomenon closely matches a previous episode which discussed how many short premium drawdowns ultimately end up profitable. In this example of the September 1575 put, we see similar results, as seen below:
This data, marking the expansion and deflation of the SPY September 1575 put leads to several key takeaways:
If you'd like a full account of this very timely episode, you can access it by following this link.
The entire library of Market Measures (including all new episodes) is accessible by following this link.
Please don't hesitate to leave any comments or questions in the space below.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on tastyworks.com.
tastytrade is a trademark/servicemark owned by tastytrade.
tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”).
tastyworks, Inc. (“tastyworks”) has entered into a Marketing Agreement with tastytrade (“Marketing Agent”) whereby tastyworks pays compensation to Marketing Agent to recommend tastyworks’ brokerage services. The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of Marketing Agent by tastyworks. tastytrade is the parent company of tastyworks. tastyworks and Marketing Agent are separate entities with their own products and services. tastytrade has different privacy policies than tastyworks.
Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on quietfoundation.com is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.