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Great post. I agree with everything you said. A few notes, though...
>Really state of the art option work is placing less and less emphasis on
>historical vol. In fact if you look at the many of the top traders and
>houses they spend their money attempting to model future vol. If you could
>generate a good estimate of future vol..you would have a veritable gold
>mine.
>
>Here is the concern. Historical has always been a poor measure of implied
>and also a poor measure of actual. Actual vol is what you would really like
>to know. Nobody has, to the best of my knowledge, created a great system
>for generating guess at actual and future vol.
Well, I think what you really mean is that we'd all like to know what the
future implied volatility will be, regardless of what the actual volatility
of the underlying turns out to be.
>
>A lot of folks trumpet the relationship between implied and historical and
>quote a lot about "mean reversion" of vol. Anyone who does any type of
>moving average work knows that mean reversion WILL ALWAYS EXIST, but so
>what. If the historical was 10 and the implied is 12, eventually the
>historical will move towards 12 with enough observations. So the concept of
>mean reversion isn't, IMHO, nearly as valuable as one might expect. Now
>there are some natural tendencies. 8% - 9% has been low for the S & P and
>30% has traditionally been high. Again so what. If vol got down to 8% you
>would probably find the whole world wanting to buy it, which means it
>wouldn't stay at 8% for long.
>
>Implied is a collection of tangible data and intangible views.
>
>The issue in ANY OPTION TRADE is NeVER the relationship between IMPLIED and
>HISTORICAL, although too many people assume it. The issue in an option
>trade is the relation between IMPLIED and ACTUAL. Now if you draw the
>assumption the future vol has a relationship to historical then historical
>is of some importance. In my view historical, except at extremes, is
>unimportant. S & P vol is currently in the mid 20's(immplied). Is it high
>or low?
Once again, I think it's the relationship between IV and what IV will be.
>
>This is where the "art and science of option trading come into
>play....especially for short term option(for longer term options or for ITM
>options vol plays a much smaller role in the overall decision).
>
>When a skilled option trader says vol is high....they are assuming it will
>be lower in the future. To say vol is high versus historical is irrelevant,
>UNLESS YOU BELIEVE THAT THE HISTORICAL LEVEL IS FACTOR IN FUTURE VOL.
>
>If you look at the American equity market for the past few years IMPLIED has
>been too low. What does that mean..it means that the buyers did better than
>the sellers of option. If you thought implied was too low..you are
>predicting higher vol down the road and you would employ trades that benefit
>from increases in vol.
>
>To the short term option trader vol can often be more important than
>direction.
>
>If you right about vol and wrong about direction you may find your trade
>won't, in fact, lose money.
Lawrence McMillan tells the story (perhaps apochryphal) about an option
trader who bought an out of the money call just prior to the crash of '87.
He paid about one point.
After the crash, this trader assumed his call was worthless. But when he
checked, he found his call has lost just 1/8 -- the result of a huge surge
in IV that day.
>
>If you are wrong about vol and correct about direction you might be shocked
>to discover that your trade doesn't make money.
>
>This is what drives a great many short term traders out of options in
>general.
>
>They find they are right about a move in the underlying...they buy/selll and
>option to fit the move and they lose money. They then draw the conclusion
>that another market, usually the cash or the surrogate(futures) is
>superior. In fact to the person who doesn't understand vol the other market
>is superior.
>
>To the person who understands vol and has a good handle on the character of
>the underlying instrument, options are vastly superior.
Absolutely. Personally, I'm not one to sell high IV because "it can't get
any higher." (it often does) But I am one to buy straddles or strangles
when any market reaches a ridiculously low level of IV. To me, that usually
signals a market wound up tightly like a spring. It has to unleash
sometime. And when it does, look out. I may not be able to predict
direction, but with options I really don't have to.
>
>As a general rule and as someone who trades and teaches options I would urge
>anyone getting into options to READ and UNDERSTAND one of the better option
>books. My two favorites, for the short term trader, are Shelly Natenburg's
>and Gary Gastinaeu's. If those book frighten or intimidate you you ought to
>consider NOT trading on very short term basis. I say that remembering that
>a part of personal income is based on option trading volume.
I think McMillans Options as a Strategic Investment is a good first read. I
think Natenburg would been too scary for me if I hadn't started with that
first.
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