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I got an interesting question from a reader about why option implied volatility is more expensive for short-term, front-month options. Here's my take on it. Here's the original question (personal data remains anonymous): Why implied volatility increase in short term? I have seen that implied volatility in oil options is higher in jun-04 contracts futures than in june-05. My question is Why dos people demand more or offer less options in the short term than in the long term? Are people less worry about uncertainty in long term? Here's my response: Hello, Thanks for the question. There's a few reasons why you'll see the implied volatility at higher levels for front-month options. Mostly this is a function of the mathematical model that calculates the options prices. Since "days to expiration" and "volatility" play a big part in determining the price of an option, you will see that the volatility component has to be increased at a higher and higher rate in order to give those options some value as the "days to expiration" gets smaller and smaller.. This is because the "days to expiration" is having less and less effect on the price of the options. So as "days to expiration" gets smaller, volatility has to get bigger in order to still assign the options a value. So if you watch options on a daily basis in the last fews trading days before expiration, you will see the implied volatility component getting larger. Also, the front-month options attract the last bit of speculators to the market as they are enticed by the cheapness of these options as they are looking to hit the home-run trade. So even though theoretically the options should be worthless, someone is willing to pay something for them for the chance to hit it big. Also, there may be players that were once short these options and they are now looking to cover and buy them back. They have to pay something for them, so these options will still have a little value. In order to give these options a value, the implied volatility component has to increase in size because the "days to expiration" component is not adding any enough value to justify the price someone is paying for it. You can't add more days to the life of an option, so the only thing that will give it value (besides where the price of the underlying security is at the time) is to adjust the "volatility" component. And that adjustment is upwards. Thanks for writing in and keep those questions coming. Lee Lowell ...thanks
for the trust you've shown in me and MrSwing.
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it out NOW.... Disclaimer: Please note that charts and commentary provided by the moderator are for educational purposes only. Any trades placed upon reliance on the moderator’s charts or information is taken at your own risk for your own account. Past performance is no guarantee of future results. While there is great potential for reward trading stocks, futures and options, there is also substantial risk of loss and you must decide your own suitability to trade. Future trading results can never be guaranteed. This is not an offer to buy or sell stock, futures, options or commodity interests. Most trading systems are based on historical formulas which have worked in the past. However, what has happened before may or may not happen again. You can lose all your money trading stocks, futures, and options and you must decide your own suitability as to whether or not to trade. Only trade with true risk capital you can afford to lose. Only trade markets you can properly afford to trade. Properly funded trading accounts typically perform better than those that are not. Never risk more than 2-3% of your account on any one trade. Always define your risk before entering a trade and place a stop to limit your risk. There are no guarantees or certainties in trading. Trading involves hard work, risk, discipline and the ability to follow rules and trade through any tough periods during a system’s draw downs. If you are looking for a guarantee, trading is probably not for you. Most people lose money trading. One of the reasons is that they lack discipline and are unable to be consistent. A system can help you become consistent. Ironically, worrying about the monetary aspect of trading can contribute to and cause a trader to make trading errors. Therefore, it is important to only trade with true risk capital. ©
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