Question

Explain what we mean by implied volatility and how option’s speculators can use their forecast of volatility to make a potential profit from their options’ positions. Explain the risks in this trade and how these risks might be mitigated.

b) Explain why various margin requirements are required for a written call option but not for a long call option, whereas for futures contracts, margin requirements have to be provided by traders who hold either a long or a short position.

Answer 1

a. Implied volatility, also known as projected volatility, is one of the most important metrics for options traders. As the name suggests, it allows them to make a determination of just how volatile the market will be going forward. This concept also gives traders a way to calculate probability. One important point to note is that it shouldn't be considered science, so it doesn't provide a forecast of how the market will move in the future.

Unlike historical volatility, implied volatility comes from the price of an option and represents its volatility in the future. Because it is implied, traders can't use past performance as an indicator of future performance. Instead, they have to estimate the potential of the option in the market.

By gauging significant imbalances in supply and demand, implied volatility represents the expected fluctuations of an underlying stock or index over a specific time frame. Options premiums are directly correlated with these expectations, rising in price when either excess demand or supply is evident and declining in periods of equilibrium.

The level of supply and demand, which drives implied volatility metrics, can be affected by a variety of factors ranging from market-wide events to news related directly to a single company. For example, if several Wall Street analysts make forecasts three days before a quarterly earnings report that a company will soundly beat expected earnings, implied volatility and options premiums could increase substantially in the few days preceding the report. Once the earnings are reported, implied volatility is likely to decline in the absence of a subsequent event to drive demand and volatility.

b. In writing a call option or any option, the loss can be unlimited if the market goes against our views. In buying an option, the loss is limited to the premium that we pay. It is the max loss that we can suffer. But the case is different in writing an option. Thus the margin is required in such cases. Margin acts as a security deposit for our losses.

If you are buying or selling a futures contract, your broker collects margins. Normally, your trading account has to be funded with margins before you can initiate a trade. Margins have to be paid, irrespective of whether you buy or sell a futures contract. Margins on futures trading are meant to cover the risk of adverse price movements. When you buy futures of the security and it goes down, there is a notional loss and that is your risk. Since markets are volatile, margins are essentially collected to cover this volatility risk.