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I am a bit confused about the impact of implied volatility on options, SPY options especially. I know that option's price decays with time and that is positively correlated with implied volatility but here some questions:

  • Question #1: Because implied volatility seems to be highly correlated with actual volatility (i.e. VXX) in the market (at least over a timescale of weeks) and because VXX is negatively correlated with SPY, buying a short-term (i.e. 10-day) OTM call on SPY seems to be a loosing bet most of the time: If SPY goes up, your call might go up in price because it is closer to the striking price but that increase might be eliminated by the decrease in implied volatility. So, what I am missing here?

  • Question #2: How should I understand the implied volatility of VXX itself? Is it just correlated with VXX or a completely different beast? (I could not find any historical data on VXX's implied volatility.)

Disclaimer: I have been learning about options only over the last 2 weeks so, I apologize if these questions look dumb.

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  • 1 : You are describing one of the reasons of the volatility skew : generally, implied volatility on an OTM SPY call will be lower than ATM (which in turn is lower than ITM) for this reason. Indeed, the magnitude of upside moves is generally lower than downside moves so your call is cheaper for this reason. Note that it is not always the case. Note also that as the spot moves up, your strike shifts down on the vol skew towards higher volatilities (which mitigates the vol lost due to "quiet markets").

Also, your 10 day OTM call will probably not have a lot of vega (volatility exposure) because its maturity is so close. You're clearly playing a move of the spot price, not a short term change in the implied vol.

  • 2 : This is called the vol of vol, there is an index called VVIX which tracks it, and yes it's a completely different beast. It's mostly used for structured/exotic products but there's a lot of research published as academics love it for some reason.
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