The prices on the options ticker might be faker than they appear.
The last few weeks have been eventful to say the least. The markets just weathered three huge events, namely:
- RBI Repo rate hike
- US inflation data
- Federal Reserve interest rate hike
In the light of these events, many people attempted to play the market using option spreads. However, many of these positions ended up in losses instead. The culprit behind this is the dreaded IV crush.
The options market is unimaginably vast. Fortunes are created or lost on a daily basis. There's a reason why experienced options traders call the market the "options battlefield".
Options are priced using the famous Black-Scholes model. It is a differential equation that takes in five input variables: the strike price of an option, the current stock price, the time to expiration, the risk-free rate, and the volatility. Countless literature has been published on options and technical analysis of options data.
It is for these reasons that it would come as a shock to many that despite option pricing being so mathematical and technical, the options market is not 100% efficient. As with equities, options can be overpriced and underpriced as well. This happens due to implied volatility in the options market.
Implied Volatility:
Implied volatility or IV is the forecast of expected changes in the price of a security. It represents the inherent uncertainty in the market. High IV causes option prices to increase while a fall in IV causes a sharp fall in the option prices. In option greeks, volatility is represented by Vega.
Why should options traders care about IV?
A high IV causes option prices to appear higher than they should be. Traders might purchase the option hoping that a movement in the underlying would cause the option price to increase. However, they get completely caught out as even a favourable movement in the underlying is not met by the same in the option contract. Instead, the price of the option tumbles down. This happens because the change in the underlying (delta) is not enough to counter the effects of the fall in volatility (Vega).
When the above scenario happens on a large scale typically after news breaks, it is known as an IV crush.
News events and the long straddle
Economic events are some of the most anticipated times for market participants. They determine the outlook for specific securities as well as the wider market in the short term. Examples of economic events include:
- Central bank announcements
- Interest rate hikes
- Earnings and Annual General Meetings
- Mergers
One very popular way to play events is an options spread called the long straddle. To create a long straddle, one buys a call option and put option at the same strike price.
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