The Implied Volatility (IV) of Calls needs separate treatment from the IV of Puts. Also, for specific options trading strategies treat the IV of both Puts and Calls as a combined bundle.
Each option at each strike implies its own individual percentage value of the underlying product’s future volatility. This makes it unique from any other option within the same chain of a given expiry month. The individuality of an option’s percentage value at each strike is what draws the “smile” in the IV’s Skew.
So, while an ITM Call has a corresponding OTM Put sharing the same strike, conversely an ITM Put has an OTM Call counterpart at the same strike, the Call must be treated uniquely as a Call and the Put uniquely as a Put. The more ITM an option becomes, its intrinsic value becomes higher and its extrinsic value is lowered. Conversely, at the same strikes where an ITM Call (or Put) gets deeper In The Money, the corresponding Put (or Call) becomes further OTM. The more OTM an option becomes, its extrinsic value rises higher and its intrinsic value is lowered. Even with ATM options, where the Call’s Delta is exactly 0.50 and the Put also has a Delta of exactly 0.50, the Implied Volatility on either side of that same ATM strike is different.
While Calls and Puts appear side-by-side for a given strike, they are not identical twins to simply trade places. Think of it this way, each option has its own Intrinsic-Extrinsic fingerprint that makes that Call or Put identifiable only to itself.
The logic for treating the Implied Volatility of Calls separate from the IV of Puts becomes obvious in the construction of specific spread types. Let’s break down the components making up the following spreads.
- A Vertical Call, be it a Credit Vertical or a Debit Vertical only uses ALL Calls. No Puts are used in the spread’s construction.
- A Back Ratio Call is typically done as a Debit spread. It is effectively Net Long an additional Call. The spread only uses ALL Calls. There are no Puts involved.
- A Vertical Put, be it a Credit Vertical or a Debit Vertical only uses ALL Puts. There are no Calls involved.
- A Back Ratio Put is typically done as a Debit spread. It is effectively Net Long an additional Put. The spread only uses ALL Puts. There are no Calls involved.
- A Put Calendar is typically initiated for a small Debit. It only uses ALL Puts. A Call Calendar is comprised of Calls ONLY.
Now, let’s compare the above spreads with these other types of spreads.
- An Iron Condor is typically constructed as a Credit spread. It uses BOTH Calls and Puts. Remember, a short Iron Condor is made up of a Credit Vertical Call combined with a Credit Vertical Put.
- A Straddle/Strangle is typically constructed as a Debit spread. It combines BOTH a Call and a Put.
Clearly, there are more spreads that require the Implied Volatility to be differentiated between Calls versus Puts, compared to the use of a combined IV. So, in choosing a data provider of Implied Volatility, make sure you get the IV data of Calls that is set apart from the IV of Puts; as well as, data that combines the IV of Calls and Puts together. That means 3 sets of IV data in one service.
We have just established the structural logic for decoupling the IV of Calls from the IV of Puts. How do you apply this to a trade? Here’s how.
- A long Vertical Call is a Debit spread. By definition of it being a negative Theta spread, also means it is a positive Vega trade. Positive Vega means the spread needs IV to rise. There is a need to forecast an increase in Implied Volatility within 30-60 days, specific to the IV of Calls for a long Vertical that expires between 90-120 days. The IV forecast must be specific to the traded product itself. Likewise, this technique is relevant for a Back Ratio Call. Apply the same logic for a Debit Vertical Put to the IV of Puts for that traded product and similarly for the Back Ratio Put. The variation of this is in a Straddle/Strangle, which is still a Debit spread, so there is still a need to forecast a rise in IV, except the IV combines both Call IV plus Put IV.
- A short Vertical Call is a Credit spread. By definition of it being a positive Theta spread, also means it is a negative Vega trade. Negative Vega means the spread needs IV to fall. There is a need to forecast a decrease in Implied Volatility within 30 days, specific to the IV of Calls for a short Vertical that expires between 30-50 days. Again, the IV forecast must be specific to the traded product itself. The same logic applies to a credit Iron Condor. However, the relevant IV to forecast is the IV of Calls combined with the IV of Puts.
- The Calendar requires unique treatment. Why? The short leg expires in a different month from the long leg. Due to this inter-month expiration in its construction, the Implied Volatility forecast requires a drop in the front month of its short leg but an IV rise in subsequent back months of the Calendar’s long leg. Remember, with a Calendar, if it is a Put Calendar, forecast only the IV of Puts. Similarly, if you construct a Call Calendar, only the forecast of the Call IV applies.
Is there a working example of a consistently profitable portfolio that treats Implied Volatility of Calls separate from the IV of Puts? Yes. Follow the link below, entitled “Consistent Results” to see a model retail option trader’s portfolio that applies this logic.
To conclude, I’ll use an analogy. Though an egg comes in one shell, the yolk is separated from the white, for a different purpose that distinguishes the individual parts of that same egg. Treat Implied Volatility of an option’s anatomy in the same way.
Thanks for reading my article, Clinton Lee. Founder, Home Options Trading: a uniquely retail-focused option-centric trading firm.
Please see Consistent Results ([http://www.homeoptionstrading.com/consistent_results/]), displaying the Model Portfolio’s Performance YTD, updated each month-end. The portfolio models a typical self-directed retail option trader’s account up to USD $50,000. Here’s the stats in summary:
Return: Profit/Start of Year Cash Balance = 75.62%. Win/Loss Probability = 90.48%. 9 Wins per 1 Loss. Average Win/Average Loss = $3.09 Won per $1 Loss. Performance Ratio = (Win/Loss Probability) x (Average Win/Average Loss) = 90.48% x $3.09 = 2.80. Positive Expectancy = $1,051 per trade.