We pay a lot of attention on how to trade the Option premiums optimally, considering the constant wasting nature of options prices. The dissection that we want to talk about today is no different from considerations already made while taking the trade. The only variation this time is that the option premiums would be looked closely with an objective of figuring out cues on the underlying.
One of the most integral parts and probably only one subjective factor in the Options premium calculations is volatility. As the rest of the four factors used in calculation of option premium viz. Underlying Price, Strike Price, Time to Expiry & Risk-Free Rate of Interest do not have any different answer.
Given the rest of the four known factors and the premium traded in the market, the volatility figure back calculated is called Implied Volatility.
Let us hold this thought and try to understand the expectations that could lead to this inorganic (if I may say so) fattening or slimming of premiums without any major change in the underlying price or time. Any option seller, while expecting higher swings in the underlying, would ask for more premium for the same period and the same strike option than while expecting a rather calmer period?
If the answer to this question is yes, we will go to our second logic of thoughts. Generally, the swings would define the speed of the move. And, the law of nature has it that creating or building something would always be less speedy than breaking or destroying something.
The implied volatility’s historical data, when compared to the historical underlying price, has more often than not been negatively correlated. Now, I hope, it is at least safe to establish that the rise in implied volatility is indicative of the rise in risk in the underlying (destructive) whereas the fall in implied volatility is indicative of the fall in risk in the underlying (constructive).
Keeping this thought process at the backdrop of our premium dissection, we can simply compare the implied volatility two sessions apart and see what course the implied volatility has taken. This dissection has particularly come in handy to me at least in periods of prolonged bull or bear phase.
Believe me; there have been times in extreme movements in the underlying when the mood across the board is extremely bearish, and you suddenly see implied volatility falling. The next thing we see could be at least a temporary bottom in place.
A similar situation could be the other way round as well, and this tiny dissection could give us a heads-up for an abrupt end to a fairly hunky-dory time in the underlying. Hence, in conclusion, I would say: keep a close watch on option premiums of an underlying, at least in the decision-making times of a fresh entry or an exit, to aid the trade decision.
(The author is CEO & Head of Research at Quantsapp Private Limited.)
Disclaimer: The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
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