Author: Clinton Lee.
The Implied
Volatility (IV) of Calls needs separate treatment from the IV of Puts. Also, for specific options trading
strategies treat the IV of both Puts and Calls as a combined bundle.
Each option at each
strike implies its own individual percentage value of the underlying product’s
future volatility. This makes it
unique from any other option within the same chain of a given expiry
month. The individuality of an
option’s percentage value at each strike is what draws the “smile” in the IV’s
Skew.
So, while an ITM
Call has a corresponding OTM Put sharing the same strike, conversely an ITM Put
has an OTM Call counterpart at the same strike, the Call must be treated
uniquely as a Call and the Put uniquely as a Put. The more ITM an option becomes, its intrinsic value becomes
higher and its extrinsic value is lowered. Conversely, at the same strikes where an ITM Call (or Put)
gets deeper In The Money, the corresponding Put (or Call) becomes further OTM. The more OTM an option becomes, its
extrinsic value rises higher and its intrinsic value is lowered. Even with ATM options, where the Call’s
Delta is exactly 0.50 and the Put’s Delta is also exactly 0.50, the Implied
Volatility on either side of that same ATM strike is different.
While Calls and
Puts appear side-by-side for a given strike, they are not identical twins to
simply trade places. Think of it
this way, each option has its own Intrinsic-Extrinsic fingerprint that makes
that Call or Put identifiable only to itself.
The logic for
treating the Implied Volatility of Calls separate from the IV of Puts becomes
obvious in the construction of specific spread types. Let’s break down the components making up the following
spreads.
❑ A Vertical Call, be it a Credit
Vertical or a Debit Vertical only uses ALL Calls. No Puts are used in the spread’s construction.
❑ A Back Ratio Call is typically done
as a Debit spread. It is effectively Net Long an additional Call. The spread only uses ALL Calls. There are no Puts involved.
❑ A Vertical Put, be it a Credit
Vertical or a Debit Vertical only uses ALL Puts. There are no Calls involved.
❑ A Back Ratio Put is typically done as
a Debit spread. It is effectively Net Long an additional Put. The spread only uses ALL Puts. There
are no Calls involved.
❑ A Put Calendar, is typically
initiated for a small Debit. It only uses ALL Puts. A Call Calendar is comprised of Calls ONLY.
Now, let’s compare
the above spreads with these other types of spreads.
❑ An Iron Condor, typically constructed
as a Credit spread, uses BOTH Calls and Puts. Remember, a short Iron Condor is made up of a Credit
Vertical Call combined with a Credit Vertical Put.
❑ A Straddle/Strangle, typically
constructed as a Debit spread combines BOTH a Call and a Put.
Clearly, there are
more spreads that require the Implied Volatility to be differentiated between
Calls versus Puts, compared to the use of a combined IV. So, in choosing a data provider of
Implied Volatility, make sure you get the IV data of Calls that is set apart
from the IV of Puts; as well as, data that combines the IV of Calls and Puts
together. That means 3 sets of IV
data in one service.
We have just
established the structural logic for decoupling the IV of Calls from the IV of
Puts. How do you apply this to a
trade? Here’s how.
❑ A long Vertical Call is a Debit
spread. By definition of it being
a negative Theta spread, also means it is a positive Vega trade. Positive Vega means the spread needs IV
to rise. There is a need to forecast an increase in Implied Volatility within
30-60 days, specific to the IV of Calls for a long Vertical that expires
between 90-120 days. The IV forecast must be specific to the traded product
itself. Likewise, this technique
is relevant for a Back Ratio Call.
Apply the same logic for a Debit Vertical Put to the IV of Puts for that
traded product and similarly for the Back Ratio Put. The variation of this is in a Straddle/Strangle, which is
still a Debit spread, so there is still a need to forecast a rise in IV, except
the IV combines both Call IV plus Put IV.
❑ A short Vertical Call is a Credit
spread. By definition of it being
a positive Theta spread, also means it is a negative Vega trade. Negative Vega means the spread needs IV
to fall. There is a need to
forecast a decrease in Implied Volatility within 30 days, specific to the IV of
Calls for a short Vertical that expires between 30-50 days. Again, the IV forecast must be specific
to the traded product itself. The
same logic applies to a credit Iron Condor; but, the relevant IV to forecast is
the IV of Calls combined with the IV of Puts.
❑ The Calendar requires unique
treatment. Why? The short leg
expires in a different month from the long leg. Due to this inter-month expiration in its construction, the
Implied Volatility forecast requires a drop in the front month of its short leg
but an IV rise in subsequent back months of the Calendar’s long leg. Remember, with a Calendar, if it is a
Put Calendar, it is the IV of Puts that needs to be forecasted. Similarly, if
you construct a Call Calendar, only the forecast of the Call IV applies.
Is there a working example of a consistently profitable portfolio
that treats Implied Volatility of Calls separate from the IV of Puts? Yes. See Consistent Results for a model retail option trader’s portfolio that applies this logic.
To conclude, I’ll
use an analogy. Though an egg
comes in one shell, the yolk is separated from the white, for a different
purpose that distinguishes the individual parts of that same egg. Treat Implied Volatility of an option’s
anatomy in the same way.