I get it. Not everyone wants to study the Greeks of options pricing. Still, everyone should know that changes in implied volatility will impact the profit and loss (PnL) of their options trades. Implied volatility can be thought of as the market's belief about the volatility of the underlying, and it is one of the inputs into an option's price. If you hold your trades until expiration, implied volatility in the future won't matter and your trade's profit or loss will be dependent only on the price at expiration. However, if you have to adjust midway or have to exit because your max loss has been hit, implied volatilities certainly will matter.
Implied volatilities tend to rise when there's uncertainty or worry in the markets or when prices drop sharply. They tend to sink when prices rally steadily but may not sink at all during sharp rallies, especially if those sharp rallies occur ahead of a potentially market-moving event. How can you determine how your trade will be impacted by changes in implied volatilities if you don't want to study the Greeks of your trade?
Easy. First look at your expiration graph and the line depicting current PnL over various prices. Let's use a simple IWM Strangle as an example, a speculative trade that I opened Wednesday, March 19.
The legend in the upper left-side shows the options comprising this speculative position. It was a neutral position opened with the idea that the RUT (and thus, the RUT-related IWM) was approaching a recent all-time high. The IWM could be knocked sharply back from that resistance test, or it could zoom above the recent high. This trade was placed the morning of the FOMC decision. Sometimes indices move big the day after such a decision, and that was especially true with potentially market-moving economic releases due the next morning. A big move either way over the next day or so would benefit the trade if implied volatilities stayed the same or rose. I should say upfront that I understood that implied volatilities were likely to do the opposite: retreat. They were likely higher than normal leading into such a market-moving event and would collapse afterward. Why did I then enter such a trade? First, I wouldn't have done so with a large positive-vega trade, but this was a small speculative one. I did it because I thought price action might overcome the negative effect of the collapsing implied volatilities. I would not suggest entering anything other than a speculative trade under such circumstances.
What wouldn't benefit this trade would be for the IWM to spend a couple of weeks at the then-current level. We see from the dark-blue expiration chart that price was hovering over the "sea of death." If the IWM is anywhere between the marked expiration breakevens at expiration, the trade's PnL lands in that sea of death. We know intuitively that the longer price hovers over that sea of death and the closer it gets to that April expiration day, the more that PnL line is going to sink into that sea of death and toward its eventual level at expiration. What isn't quite as intuitive for those who don't want to immerse themselves in the Greeks of options pricing is the effect on the PnL of changing implied volatilities.
Here's a simple (and somewhat simplistic, of course) way to remember the general effect: if implied volatilities sink lower, the effect is the same as the passage of time. The PnL acts as if the days have marched forward, closer to the expiration date. If implied volatilities rise, it's as if the calendar is rolling backward and there's more time to expiration.
What would be the effect on the pictured trade then, if price stayed in the same place and implied volatilities moved lower? We know that the closer the calendar moves to expiration, the more that PnL line is going to sink into that sea of death. Let's put our simplistic guideline to the test and lower implied volatilities by using the "Volatility Adjust" feature on the OptionNet Explorer software I use. Remember that my Options 101 articles are roughed out and charts snapped a week or two before publication, so I didn't have any information at the time about what would actually occur. This is the dilemma facing options traders: they may think they know what will happen next, but they have to plan for all eventualities. This is one way to do it.
Same Trade, Same Day, with Implied Volatilities Lowered via the "Volatility Adjust" Feature on ONE:
As anticipated, lowering implied volatilities has made this trade look as if time has passed and the expiration date is much closer. In the area of the sea of death, the PnL line has sunken toward the bottom of that sea. (Note: when the IWM consolidated for a week before dropping this last week, that PnL line did indeed drop in just this manner, although the interim loss to the position was never as high as $207.)
What if we roll the implied volatilities higher and look at the theoretical effect? I imagine by now you can anticipate the effect.
Rolling Implied Volatilities Higher:
Raising implied volatilities has raised that PnL line. With rising implied volatility, the PnL acts as if the calendar has been rolled back and there's more time to expiration. Since the trade was opened on March 19, the date displayed, the debit I paid is cheaper than the debit that would have been required a week or two earlier, when the bought options had more time premium in them. Therefore, the trade is acting as if I immediately had some profit because I scored a bargain price.
As mentioned, this guideline is a simplistic way of imagining the effect of changes in implied volatilities on a complex trade. This guideline does at least provide a quick way of imagining the impact for those who are considering the likely impact of an earnings announcement (when implied volatilities build in the immediate period before such an announcement then are often released afterwards, depending on price action) and other such effects on their trades. If you're expecting implied volatilities to drop after such an announcement and you think prices would steady for several weeks, would you want to open this particular trade? No way. (Note: when the IWM chopped out a consolidation zone for a week after this trade entry, the PnL dropped, but by Thursday, March 27, the IWM had reached my target price, implied volatilities had risen, and I was able to exit for a profit.)
Knowing what you know about the trick to imagining the effect of changing implied volatilities on a trade, what about this for a lottery-money trade on March 19 if you had been expecting implied volatilities to drop and price to steady for several weeks, unlike my supposition that they would soon break sharply one direction or another?
Hypothetical Speculative Trade with Lottery Money, Pictured on March 19:
This is not a trade suggestion but is rather an invitation to imagine the way that lowered implied volatilities and price consolidation for a couple of weeks would impact the PnL on this trade.
Of course, those who do understand the Greeks of options pricing will observe right away that this last graph pictures a negative-vega trade, one that benefits from a reduction in implied volatilities and is hurt by a rise in implied volatilities. The first three graphs depicted a positive-vega trade, one that is helped by a rise in implied volatilities and hurt by a drop. This trade, unlike those others, would have theoretically benefitted from consolidation near the then-current price and lowered implied volatilities. By early morning on Wednesday, March 26, the consolidation had dropped the loss to $4.00 from its original $20.00, with that $20.00 being the cost of the commissions to both enter and exit the trade. The trade was benefitting from the consolidation and lowered implied volatilities, just as my actual live strangle was being hurt by that same action. Then price action and rising implied volatilities punished this theoretical trade at the same time it was bringing my live strangle to profitability.