A common and oft repeated belief regarding options volatility is that implied volatility increases due to people bidding up a contract, usually related to anticipation of the outcome of an expected event. After the event, volatility drops because more people are selling the contracts.

But I have noticed contracts with ZERO volume with an increase in IV, and after the event those same contracts with ZERO volume now are quoted at lower prices after IV has dropped. The only market participants that are "bidding up" or "bidding down" are the market makers, and they never fill each other, just change their quotes.

The fallacy is that nobody is interested in those contracts therefore IV should not increase. The market makers' computers simply change their bid and ask because the IV has changed, not the other way around.

Is there a more comprehensive options volatility study I can read that more accurately addresses change in volatility? I have reservations about what is commonly said about volatility vs what I see in the market.

On these illiquid contracts, perhaps the long standing idea of implied volatility is simply of no use here, and if people really think these contracts are worth what they are, then the portion of the contract's price that is based on IV should be spread out amongst the other variables, mainly theta.

  • $\begingroup$ You are right, there is a common, oft repeated, and false belief that the price of anything rises or falls because people are buying or selling. For every buyer there is a seller. Options are no different. Direction of trade initiation is not what moves prices. $\endgroup$ – Tal Fishman Jul 9 '12 at 11:20

The way market makers mark their volatility curves is by using models which 'fill in the gaps', i.e. they will make a price for a given option even if they do not believe this option is going to get a lot of volume. They are still willing to go long/short because they have a strategy to hedge their overall position (i.e. by managing their greeks and expiries).

So they make some assumption on what the overall vol curve is (as function of time / strike), and also of how the ATM vol relates to perhaps some more liquid underlier (for example they will use the vol for a sector index as a proxy to vol for a single underlier).

Therefore, the price (and therefore the implied vol) may change even when there are no transactions, just because some of assumptions or market parameters have changed. If the implied vol increases for one particular option, it may be not because demand for that option has gone up, but just because demand for other options (which are considered related) has gone up.

  • $\begingroup$ Your overall answer is right, of course, but to clarify, a change in demand does not imply actual buying or selling. To say price has changed because supply and demand have changed is tautologically true. Likewise, demand for the specific option has gone up, even though there haven't been any actual trades. $\endgroup$ – Tal Fishman Jul 9 '12 at 11:24
  • $\begingroup$ No indeed - change in demand does not imply actual transactions, but the role of the market maker is to have some idea of where the market is, and bid slightly lower / offer slightly higher so he makes money (at least if he's right about his assesment of the market and/or manages to offload his risk early enough) $\endgroup$ – joelhoro Jul 9 '12 at 14:14

The mistaken belief you refer to is a common confusion between stating that the price went up because demand went up and/or supply went down (tautologically true, but meaningless statement) or because buyers entered the market and/or sellers exited the market (usually false). This has nothing to do with options or implied volatility. I see such confused statements in the popular press regarding all sorts of markets, financial or otherwise.

All it takes to make a market is one buyer and one seller. Sometimes these can even be the same person, willing to buy or sell at different prices. If new information comes along, such as the arrival and passage of an "expected event", then all market participants, buyers and sellers, will rationally change their prices. This was true before computers and would be true even if there were only one listed option with no possibility to reference to other options. What you say has absolutely no bearing on the value of a concept such as implied volatility, which is nothing but a theoretical construct people use to communicate. At the end of the day, every trade, even trades quoted on implied volatility, are transacted at a real price in some real currency.

As for what to read regarding options volatility, I'd recommend Hull's Options, Futures and Other Derivatives, and stop reading the popular press about options or markets in general. They will just confuse you.

  • $\begingroup$ for reading I opt more for VIX white paper and that sort of thing, but I suspect they aren't the most impartial straight to the facts sources out there. I'll check out Hull's book $\endgroup$ – CQM Jul 9 '12 at 14:57
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    $\begingroup$ @CQM VIX white paper is just a very specific document regarding their methodology for an index they created, not meant as a practical guide to understanding implied volatility. $\endgroup$ – Tal Fishman Jul 9 '12 at 15:01
  • $\begingroup$ @CQM Let us continue this discussion in chat $\endgroup$ – Tal Fishman Jul 9 '12 at 15:33

The implied volatility as its name suggests, is implied from a price, be it the last traded price, a bid or an ask price. In the case where there has been no trade for an option, the implied volatility is likely to have been calculated from the bid/ask (or the mid-quote).

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    $\begingroup$ the problem is that changes in implied volatility are SAID to be because of changes in demand on that contract. But instead, the quotations from the market makers are only changing because of implied volatility, where there is no demand. $\endgroup$ – CQM Jul 7 '12 at 14:06

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