When trading options, we're told we need at least a passing knowledge of implied volatility. Implied volatility is the spot estimation of how volatile the underlying's price is likely to be. Historical volatility is a measure of how volatile the underlying's prices were. It's implied volatility that constitutes an input into an option's price. It's important to options traders. Is it rising or falling? Some options trades will benefit from rising implied volatility and others, such as iron condors and long butterflies, tend to be hurt by rising implied volatilities.
Live Butterfly Trade on Friday, January 9, When Composite Implied Volatilities Were 18.90 Percent, OptionNET Explorer Graph:
In the following graph, I moved the date forward and input a theoretical rise in implied volatility to determine how those changes would change the theoretical profit-and-loss line.
Same Trade, Date Rolled Forward to Tuesday, January 13, with Volatility Adjusted Higher by Three Percentage Points:
Pushing the implied volatilities higher weighed down the PnL line, sinking it. The effect may be difficult to see, but you can compare the two losses at the same price and determine that it's deeper on the second chart even though the passage of four days' time should have lessened that loss.
When studying the OptionNET Explorer page for this trade, I can see a second pulldown tab at any price point. I placed it at about 1,170, although I am unable to snap a picture of that second pulldown tab. The theoretical loss at 1,170 with these conditions changed would have been about $1,197.
Actual Live Trade on Tuesday, January 13:
As you can see, the theoretical loss under live trading conditions was much lower than had been anticipated when testing certain conditions back on January 9. Although implied volatility had risen the amount tested and price was at about the price tested on the rolled-forward January 13 date, that loss on that actual date when the trade was live was only about $550. What happened? We know that this effect wasn't just due to the passage of time because that passage of time was factored into the predicted $1,197 loss.
Put Skew of February 2015 Monthly Options (Green) versus December 2015 Monthly Options (White):
This skew chart plots the implied volatility of an option on the vertical axis and the strike price of the put on the horizontal axis. We can compare the two series pictured and determine that the February skew graph was taking on a different shape than the December 2015 series. On the left-hand side of the chart, picturing the portion of the curve relating to the out-of-the-money puts, the line curves up much more sharply than the comparison December 2015 skew curve. Although since the crash of 1987, OTM puts on equities typically have out-sized implied volatilities, that's particularly true in the February cycle.
Why is that? On a down day, options traders, speculators and big money people, too, were likely buying OTM puts to speculate or protect their positions. That increased demand in those options inflated their prices and increased their implied volatility when compared to ATM options. The skew sharpened.
The point? When we visualize the effect of rising implied volatilities, we might mistakenly visualize the rise's effect across the options series as being like the rising flat back of someone planking to increase core strength. Instead, the skew chart curves up on both end, and that curve may flatten or sharpen, depending on conditions. When prices turn down and implied volatilities tend to rise, you could visualize the shape of the skew curve differently, taking on the shape of someone doing crunches with raised legs to increase core strength. (Okay, it's a dumb comparison, but it's easier to remember this way.)
The shape of that skew curve is going to impact the way the profit-and-loss line behaves. By definition, my butterfly is going to have some strikes that are nearer the money than others. Notice that the skew curve also climbs with the ITM puts, although not as steeply as the OTM ones. The long strikes--the ones I owned--were plumping up both due to price action and to the rise in implied volatilities as the skew changed shape. They were perhaps plumping up faster than the options at the sold strike due to the shape of the skew curve.
In addition, I always add an extra long put in my short vega trades. I add it as a volatility hedge, not necessarily a price hedge. (Note that I'm not recommending this for everyone. It's an extra insurance due to our risk tolerance and age, and I pay for it in outlays and less profit.) I know that, in the event that markets roll over, an OTM put is likely going to gain value at a faster clip than some other puts that comprise my trade.
My original purchase price for my extra long put was $13.15. As my live trade was snapped on January 13, the price of that put--the February 15 1120 put--was $17.45. While my deep in-the-money hedging call was losing price, that put meant as a volatility hedge had gained $430 in value.
That chart illustrated a theoretical value because I hadn't actually tried to close the position that day and determine where fills would or would not occur. Prices were not always steady, either.
Unless you're specifically going to be trading volatility, you probably don't have to read tomes on implied volatilities. You don't have to study skew charts. However, it is important to realize that IV's are probably going to rise whenever there's uncertainty in the market. In addition, the reason for the uncertainty is probably going to impact the shape of the skew. Often the effect is to drive up the prices of the OTM puts, although that's not always true. If IV's are rising ahead of an announcement due to uncertainty, but buyers are actually lurking just waiting to jump on board as soon as the announcement is out of the way, the put skew chart might not be changing as much as expected, but the call version may kick up because so many OTM calls are being purchased.
In that kind of situation, jumping in ahead of time to buy an extra long call may not be the absolute best choice for speculation or even for hedging. If the announcement goes well and price heads higher, the IV's may drop. Those OTM calls you bought may lose value unless the rally is a steep one. Some people use call verticals to hedge the upside when they expect implied volatilities to drop.