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I thought implied volatility, as well as the VIX, primarily increase due to increases in the underlying asset's volatility, as well as the options themselves being bid up because more people were buying that usual.

For instance, during an IV crush, usually people are selling the contract heavily. When IV is building, I thought people were buying the contract heavily.

Today, I was watching a spread and noticed a leg was becoming more expensive than predicted, yet the volume was low, the open interest was also low, and the VIX was unchanged. It wasn't just this contract; the entire side of the book for that month's contract had elevated volatility.

I don't understand how this happens. Could someone shed some light on how the IV increases without people bidding things up?

There were no catalyst events coming up, and the underlying asset wasn't a corporation's stock. It was an ETN on an index.

My next clue would be that the IV is based on historical volatility, such as when things start moving in one direction that things can really swing, so the pricing of the contracts were fixed to include this expected demand for their premium. But I could also be way off.

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It looks like you've had this confusion regarding how markets work for a while. Note that Brian B was saying that with an ETN it probably had to do with options in the components, but really this is not necessary. Prices of anything, such as houses, like he mentions, can change even when nobody is trading. –  Tal Fishman Jul 9 '12 at 15:05
    
yes, there is a bit of cognitive dissonance, as I completely disagree with what I've read about how the markets works, simply by observations. so I would like to get to the bottom of this –  CQM Jul 9 '12 at 15:12

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I'm going to go ahead an assume the spread you were looking at involved exchange traded options. As you presumably know, the actual implied volatility on your screen is a number derived from option prices by running the Black-Scholes model "backwards" from quoted option price to volatility. Higher prices imply higher volatility.

That last statement is the key: the quoted prices can go up, and so the implied volatility can go up, even if nobody trades (so that open interest remains unchanged). It's kind of like the housing market in that the presumed asset value goes up even when nobody trades it.

With an ETN this probably had to do with option prices taking off in one of the underlying components.

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"With an ETN this probably had to do with option prices taking off in one of the underlying components." how exactly does this work and how is it tracked? –  CQM Feb 2 '12 at 4:49
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I just mean the market makers may have noticed heavy trading and increased options prices in one or more of the major components of the ETN. Therefore they increased their quoted ETN option prices, thereby giving rise to larger implied vol of the ETN option market. –  Brian B Feb 3 '12 at 13:59

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