By Frederic Palmliden, CMT Senior Quantitative Analyst, TradeStation Labs TSLabs TradeStation. View the Characteristics and Risks of Standardized Options. An implied volatility surface is a three-dimensional plot that reveals implied volatility data for a number of different options series for a particular underlying security. This paper introduces a "near real-time" version of such a surface, which dramatically facilitates spotting timely trading opportunities.
This valuable trading tool is not just intended for options traders, but also for any trader who is attempting to identify market expectations, temporary anomalies, and asset valuations. A custom indicator and workspace that utilize new functionality only available in TradeStation 9.
In finance, the volatility smile is a long-observed pattern in which at-the-money options tend to have lower implied volatilities than in- or out-of-the-money options. The pattern displays different characteristics for different markets and results from the probability of extreme moves. Equity options traded in American markets did not show a volatility smile before the Crash ofbut began showing one afterwards.
A closely related concept is that of term structure of volatility, which refers to how implied volatility differs for related options with different maturities.
An implied volatility surface is a 3-D plot that combines volatility smile and term structure of volatility into a consolidated view of all options for an underlier. The following table contains a description for each of the inputs used by the custom indicator discussed in this paper. The term "surface" will refer to the implied volatility surface throughout the paper. The TimerInterval in Table 1 above helps the transfer of data from the TradeStation platform to Excel by specifying when to run the different calculations within EasyLanguage set to 2 seconds by default.
Depending on your processor speed and system characteristics, this time interval may need to be adjusted, or you may want to turn the Timer off altogether by using a 0 for this particular field. Aside from the different indicator inputs listed above, the options ticker symbols for the different options series also need to be compiled in order for the Implied Volatility Surface indicator to send the appropriate data to Excel.
The most important part of the process is to have the correct order for the different options ticker symbols, since each point of the surface has a designated cell in Excel.
The format described in Table 2 will be used for this paper in order to copy the options ticker symbols from OptionStation to RadarScreen. Notice from the table below that the different months are listed in order from the nearest to the farthest month. The nearest month is the front month, the month closest to expiration. Also, for each month, the strike prices are listed in ascending order, starting with the lowest strike, which is four strikes lower than the at-the-money strike price.
Lastly, this process is duplicated five times using five progressively longer expirations, alternating seven calls followed by seven puts for a total of 70 options contracts. On a side note, if options contracts are missing, due to illiquidity for example, the place of the missing data in a RadarScreen row should be left blank to avoid sending misaligned implied volatility data. Also, at times, options series are not exactly consistent across maturities with slightly differing strike prices. If this occurs, discretion should be used as to whether or not to include particular options contracts.
In order to construct the implied volatility surface for International Business Machines Corp. IBMthe following process will be carefully utilized:. Numerous applications can be explored with the implied volatility surface ranging from studying the options of the implied volatility, to finding market anomalies, to gauging market psychology.
One particular application would be to create a synthetic implied volatility surface for an equity index in order to compare the resulting surface to the surface of an individual index member, the surface of the index's tracker, or the surface of the excel futures contracts.
On the other hand, a synthetic implied volatility surface can be created by assembling the index members' surfaces. Assembling the synthetic implied volatility surface from the 15 individually weighted surfaces on June 3,resulted in the surface depicted in Figure 3 below.
This surface can then be compared to individual members' implied volatility surface for trading opportunities. Such an application will be discussed in the "Trade Example" section of the paper. Several observations can be made from the chart above. First, notice the reverse vertical implied volatility skew across strike prices. As a reminder, there are two main types of vertical implied volatility skews: A reverse vertical implied volatility skew is present when implied volatility is higher at lower options strikes and implied volatility is lower at higher strikes.
A permanent reverse implied volatility skew is common for options on excel market indexes, but the skew can be amplified following market drops, such as in Figure 3 above. The existence of this phenomenon is often attributed to the possibility of a strong market sell-off not captured by the options pricing models.
Second, notice the horizontal skew across expirations in Figure 3, which occurs when different implied volatility readings are observed across the different options contract expirations for the same strike prices.
The most typical horizontal skew is when implied volatility is higher for the front month versus the other maturities. This phenomenon, which is observable for options across asset classes, can be attributed to expectations of price moves around upcoming news events or supply conditions. Last, it is interesting to note that the synthetic implied volatility surface for the Dow Jones Industrial Average can be quite different from the surface of the SPDR Dow Jones Industrial Average ETF tracker DIA.
A forward implied volatility skew versus an expected reverse implied volatility skew was observed at the time not shown in this paper. The discrepancy highlights the importance of constructing a synthetic equity index implied volatility surface, which can be more in line with the surfaces for individual index components versus using the surface of the equity index tracker.
Common mistakes by traders include buying high implied volatility and selling low implied volatility. Even if a trader correctly predicts the direction of the underlying security, movements in volatility can turn an options strategy into a losing trade very quickly. Therefore, it is very important not only to measure implied volatility relative to recent implied volatility and to historical volatility, but also to align the options strategy employed with the projected move in volatility going forward.
This brings us to one of the options Greeks — namely vega, which is crucial to understand before establishing an options position. Vega is a risk measure of the sensitivity of an options price to changes in volatility. According to Lawrence G.
McMillan in his book McMillan on Options, "Vega is probably not a familiar term to most options traders, but it should be, for nothing affects the price of an option so dramatically as the volatility. Table 4 below summarizes the impact of volatility, aside from other factors, on common options strategies. As an example, a trader would not generally want to buy a call after a steep market downturn, since volatility at that point would more than likely be high and collapsing volatility going forward would likely erode the options premium even if a rebound takes place in the market.
The following theoretical trade is just one example offered for illustration purposes, and should not be construed as a representation of what should typically be expected when utilizing the implied volatility surface discussed in this paper.
After constructing the implied volatility surface for Wal-Mart Stores WMT and monitoring the options real-time progression of the surface versus the surface for the synthetic Dow Jones Industrial Average 30 Index, the lower left corner of the surface showed an implied volatility reading far above what would be expected during the second week of June see Figure 4 below.
Commissions and slippage are not included in this example. The implied volatility surface provides valuable information to all types of traders by combining large amounts of data into one graph.
The excel can be studied, analyzed and utilized in trading across asset classes and holding periods for various types of trading methodologies. The near real-time aspect of the surface, made possible with recently introduced functionality in TradeStation 9.
The upcoming "Analysis Concepts — Meet the Author" online event will discuss this topic further. Implied Volatility in 3-D. All excel, education and training services and materials on the TradeStation website are for informational purposes and to help customers learn more about how to use the power of TradeStation software and services.
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Time input in milliseconds for the Timer Object. A value of 0 will turn off the Timer functionality.