Buying Options in this Underlying fair value?

So I learnt that when Historical volatility is about equal to Implied volatility, your not overpaying for options - now if you look at the chart below, IV is about equal to HV - so by buying puts/calls in MMM OK from a fair value point of view?

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I'm an options beginner so take my comments in that context.

Firstly you are discussing long options positions so I'm assuming you are not looking to short volatility or theta or do arbs around any of the other greeks etc. but are basically looking to capitalise on a directional move in the price of the underlying.

On that basis, whether you are paying too much IV, depends on your view on where the underlying volatility of the stock price is headed. Based on that chart below, the underlying stock price volatility has spiked significantly compared to any other time in pretty much the past two years. I don't know the stock so can't speculate on the reason the volatility has spiked - but unless you expect this very big change in volatility to continue then you should expect the IV's in your long options (long puts or calls) to collapse as the volatility in the underlying collapses.

If the volatility collapses then depending on where your strikes and dates are you may find that even if delta moves in your favour the IV collapse erodes the value of your options faster than the delta move inflates them.

Without knowing the stock or the circumstances that have led to the high volatility its hard to offer an opinion - but volatility spikes are usually due to some event occurring (either some news event or some technical event like a breakout) and the heightened volatility rarely lasts long - you'd typically expect the volatility in the underlying to collapse, and would be hoping that the delta moves fast enough to counteract the IV collapse.

I'd be modelling an IV collapse alongside whatever delta move you are trying to capture and then looking at different strikes away from the money to see where you get the optimum outcome for your target moves - but overall it looks like a an expensive time to be opening long options positions from an IV perspective.

Seneca60BC said:

So I learnt that when Historical volatility is about equal to Implied volatility, your not overpaying for options - now if you look at the chart below, IV is about equal to HV - so by buying puts/calls in MMM OK from a fair value point of view?

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Generally a guide thrown around is if HV > IV - options are "cheap" and HV < IV options are "expensive". But that shouldn't be set in stone and the only reason to be long/short vega

Looking at MMM - the IV is at new record levels compared to the past
Is IV really cheap?? Its highest used to be 35% while now its around 75%!!!

The other assessment you should make is what do you think IV will do in future? Say you think it falls

Does it look like it will jump up in the short term or the time frame you are trading - or mean revert? Say you think it falls again

So even if you may buy at perceived fair value because IV = HV - but if IV drops your still a goner since you are long vega (assuming all other variables remain constant)

At the moment premium's are quite high to be purchasing single options

Hahaha
Cuttlefish has beaten me to it and in much better technical terms too!!!

but overall it looks like a an expensive time to be opening long options positions from an IV perspective.

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Just to qualify that this does not necessarily mean it would be a bad trade - you may have a reason to believe that the high volatility in the underlying will continue or that there will be a large enough move in the underlying price during your target timeframe to counteract any collapse in volatility - but its important to be aware you are paying a higher IV than at any time in the past nearly 2 years and factor that into your assessment.

mazzatelli1000 said:

Hahaha
Cuttlefish has beaten me to it and in much better technical terms too!!!

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Was wondering as I was typing away if that might happen. Good to see that we seem to be saying pretty much the same thing anyway!

cuttlefish said:

If the volatility collapses then depending on where your strikes and dates are you may find that even if delta moves in your favour the IV collapse erodes the value of your options faster than the delta move inflates them.

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Seneca
Best thing to do is simulate these movements in Hoadleys or something similar

cuttlefish said:

Was wondering as I was typing away if that might happen. Good to see that we seem to be saying pretty much the same thing anyway!

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Definitely a good sign!!!

Nothing to add to the excellent points above, but just a comment on the term "fair value".

The term is usually used to describe the worth of an option or futures contract as determined by a mathematical model, viz using HV. But as we have all discussed, HV looks backward. What the trader wants to know is what will be the realization of volatility going forward.

Therefore fair value in the sense above is a nebulous concept, because we can't see the future. If we pay up for an option at 50% IV because HV was 50%, and the realized volatility drops to 25%, we haven't got fair value, in hindsight, at all.

I like to look at fair value as being in tune with my volatility projection, therefore for me, fair value might not be anywhere close to that value determined by HV. It's a guess, but it's what I think is fair.

Hence "fair value" is really intrinsic to projected IV as per mazza's and cuttlefish's comments above.

OK - yea so if IV is high and one thinks IV is going to get higher than it is safe to buy options -

what I am trying to say is that with the current climate - simply selling options because IV is high is taking on a narrow view because I have seen option prices climb even higher and higher even though IV is very high -

it comes down to a bet on the direction of the underlying - if one suspects further falls very quickly, then its quite safe to purchase options with the risk that IV could drop.

Cheers!

Seneca60BC said:

OK - yea so if IV is high and one thinks IV is going to get higher than it is safe to buy options -

what I am trying to say is that with the current climate - simply selling options because IV is high is taking on a narrow view because I have seen option prices climb even higher and higher even though IV is very high -

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YES! You got it.

Seneca60BC said:

it comes down to a bet on the direction of the underlying - if one suspects further falls very quickly, then its quite safe to purchase options with the risk that IV could drop.

Cheers!

Click to expand...

Yes, but it's likely that further fast falls will increase IV. You win with delta and vega. The danger is that if you own a put at high IV an the stock starts moving up against you, volatility will fall, so not are you losing on delta, vega is giving you a kicking as well.

But bear in mind that you can then alter your risk profile by selling a put at a different strike to suit the new reality, rather than just exiting. (If that's what you want to do)