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Minyan Mailbag: Implied Volatility



Editor's Note: Minyanville is a community of people who share an interest in fiscal literacy. As perspective is an important aspect of our daily routine, we share this exchange with hopes that it adds balance to your process.


The chart of Hilton Hotels (HLT) looks bad.

I checked out a chart of the implied volatility (from for HLT's options and I noticed that the IV was really low and then it ramped up.

To me, that is a recipe for a big move (with the trend - down) because the option-sellers have covered and now the "dealers" (generic term) are short options (short
gamma) [maybe they aren't short the options yet - they could just be "less long" the options, which would mean that they are not buying dips and selling rallies to the degree that they were, thus letting the stock do what "it wants to do"], so they are going with the trend.

Minyan Ryan


I have been long volatility in this name and I have a somewhat different take on the several points of the situation, although I generally agree with your conclusion.

You are correct that the implied volatilities of the options have increased somewhat after a somewhat large move in the stock. This large move was not all in one day in what we call a tail event, but rather in more of a "significant grind down": the stock has dropped 11% over a span of about 15 trading days representing a 42.5% actual volatility ( ln (1.11) x sqrt (250/15) over that span. Interestingly though, the largest close-to-close change in the stock (although more important to me was the largest intra-day move) was only $0.50, representing a 30% actual volatility (consistent close-to-close volatilities of less than the overall volatility of a move qualifies as a "grind").

Regardless, the day-to-day and the overall actual volatilities of the stock have been above the implied volatility of 20% where I bought the options (Jan 25 calls), so I have made money on this position. But, I made more money than if I had re-hedged according to my deltas each day, which I didn't, because of something David Miller said the other day, and which is especially important in derivative trading: try to understand who is on the other side of the trade and what they are trying to accomplish.

In this case I am assuming that the other side of the trade is a seller of calls (let's call her S) who is long the stock "one-up"; this means that S is short calls equivalent to long shares of stock ( e.g. short 1000 1/25 calls and long 100,000 shares of stock). I have several reasons for believing this; I won't go into details, but suffice it to say that I pay particular attention to how the seller goes about executing and to both the stock's option market and the overall market in general. S's objective is to capture the premium sold in the options. Generally, this is more effective when option prices are high (sell high buy low is somehow forgotten in this market of momentum) and done selectively. In this case the options sold by S were cheap.

In the following description it is important to note that I am a relatively high percentage of the open interest as is S. The more liquid a stock and its options are, the more the risk is spread out, the less important it becomes how any individual participant responds. Option activity, open interest, actual volatility, and many other technical variables become less important the more liquid a situation is.

As the stock dropped and began trading at a higher actual volatility than that which was implied in the options, the option prices naturally rose in relative price. As a result, I gained the upper-hand: S began to experience losses, while I began to experience gains. How I respond to this becomes important to S: if I respond by trying to capture gains by either actively re-hedging or by selling options, this will reduce the pressure on S. Napoleon said, "Never interrupt your enemy when he is making a mistake." The first mistake S made was to sell the options too cheaply, so I want to encourage S to compound the situation and continue to make small mistakes. The best way to do this is to not help her.

So I under-traded the delta, carrying short deltas on the way down, and did not sell options at the first sign of an increase in their prices, in an effort to not mitigate the volatility and put pressure on S to increase the volatility. I did this until the option I was long began to lose a certain amount of its gamma.

On Friday with the stock down another $0.40 the time had come to fully re-hedge my position. But I did not do this by buying stock. With the options still around 23% implied volatilities with the stock having made a fairly good move, I decided to increase the pressure and buy more calls (of a different strike) to hedge my delta. This also brought my gamma back up to my original position.

I did this partly because I believe that the company is planning to under-go a major restructuring, which could bring several more large moves in the stock over the next several months (either up or down). I also do not believe that the option sellers (S in particular) have covered: S has not bought back her calls. If she is selling stock here to "re-hedge" and she is still short those original calls, S could experience a nasty situation if the stock rallies back: she will either have to buy stock back higher or buy the calls back. The worst scenario for option sellers are large trading ranges.

And of course that is what I would like to see the most.

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