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Sep 9, 2015

Option Prices | Why Do They Fluctuate?

By:Sage Anderson

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:

  • Option prices are driven by implied volatility
  • Perceived risk in the market drives implied volatility
  • Perceived risk changes over time, explaining the expansion and contraction of option prices

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.

Happy Trading!

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

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