i have done a lot of reading and research on options in the last couple of weeks. trying to find ways of determining fair value. of course the easiest part of it is intrinsic value, if any. the current difference between the strike and underlyer. next easiest(in theory) is time value. for fairly short dated options and ultralow interest rates, it is a small and relatively constant number until you get real close to expiration. the worst factor to calculate is market demand for a particular strike and expiry. for the purists, supply might well be infinite.
the only way to gauge demand is the mismatch between the volatility of the underlying shares and the volatility backed out of some model and the current option price. the implied volatility. in general, every option pricing model i have come across results in a fair value that is higher for higher volatilities. the headache comes in getting live information for the implied number. TD gives me an overview, sort of, using numbers that have questionable sources. Trade King, which styles itself an option house, gets better numbers, but only one option at a time. still too much clicking.. after finding a site with much batter data, a whole chain at once, i started the experiment.
AGNC near the money puts and calls for the next two months have an implied volatility much lower than the historical share's volatility., suggesting that they are under-priced. GE for example, is the exact opposite, suggesting over-priced.
so i bought some AGNC May 32's when their implied volatility was 14% versus the historical volatility of 21-ish. goona see if it makes any difference.
I might be wrong but I was not under the impression that a variance between option historic volatility and current implied volatility had anything to do with a current option's fair value. Let me clarify. Historic volatility has to do with the previous time periods(eg 12 month) underlying stocks daily fluctuation. The stock can remain at a daily "last" every day for the past year @ the same value, say 31.67, yet have an incredibly high historic volatility because of the daily fluctuation of the stock between high and low. So the PPS again can remain rock steady at the same "close" day after day forever and be off the charts in historic volatility.
So does that influence implied volatility as your statement suggests? I say not necessarily. The reason, IMO, is that implied volatility is based upon perceived movement in the future of option prices. Well we just came off of the run to EX...lots of fluctuation of the underlying price over the past month or so especially with the SPO and all of the little piranha's feed fest(including me...;-))
Now we are in the expected doldrums again with boring option fluctuation projected for the foreseeable future, hence low implied(implications for expected option fluctuation) or expected volatility in option pricing otherwise known as implied volatility.
So , I humbly submit, that historic volatility is based upon the fluctuations in the past stock price whereas implied volatility is a function of the projected option fluctuation. Just because you see current implied volatility being less than recent historic volatility does not , "suggest" that the current options are "under- priced" .
On the contrary I think they are just as expected heading into the doldrums of the shoulder season.
entirely true, Doc. which is why i kept looking until i found a place that (supposedly) computes the HV on the same basis and time periods as IV.
this is an experiment, people. i am trying to find out if IV approaches HV as expiry nears.
current, near the money, AGNC options through May(no dividend ex), suggest that the options are under-priced by the market. a demand side thing. i have no preconceived ideas here. merely risking a little bit of capital to find out if i am chasing the market fairies or not.
BTW, the same data suggests that put options are more "fairly" priced than calls, by a small amount. FWIW, the call options i bought yesterday are now ITM by a little, and the IV(implied volatility) decreased.
"implied volatility isn't based on perceived fluctuations
it's based on the fluctuation necessary to justify the given price"
The ATM option values on the front contract months "tell" us what the market "perceives" the future underlying stock movement is expected to be in a Log normal projection. As an example, if an upcoming "event" is expected to dramatically affect the underlying stock price you will find a dramatic increase in implied volatility.
My original point: This perceived future change to the underlying stock price is what changes the implied volatility(which is ascertained by the current fluctuation in the option pricing set by the market traders in the ATM option pricing).
As can be then seen this implied( ask yourself what the word "implied" means) volatility tells you what the market "thinks" will happen(currently and in the future), not "historically" ( in the past). The implied volatility therefore does not necessarily suggest that options are currently "under-priced" as the original poster stated. Sure they might be more or less expensive than they were last week, month or year(historically), but are they "under-priced" in terms of what "might" happen in the near future, which is what implied volatility is all about?
So go ahead and buy your "cheap" AGNC options which are supposedly "under-priced". The market "expects" ..."future"...lower...."implied".... volatility, and so do I....;-)
implied volatility isn't based on perceived fluctuations
it's based on the fluctuation necessary to justify the given price
if that is out of line with historical fluctuation, whether being a larger or smaller amplitude, then that suggests the market is not in equilibrium
and if the theory is that the historical fluctuation is the equilibrium, then the strategy is to buy when the implied volatility is lower than the historical and sell when it is higher... sounds familiar, this buy-low-sell-high thing... only this time you have a way to gauge whether it is low or high.
of course, it breaks down when forces outside the market have changed the underlying stock's distribution of random fluctuation to a non-random fluctuation for some reason. like...say...a SPO or a div... or a whole bunch of them in a sequence with some predictability...