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How changes to Implied Volatility impacts option prices

Posted Jun 12 2020

In a case study, we looked at a TSLA Long Call trade whose estimated profits went from +8% to a 5% loss. Why? Since opening the position, the IV changed significantly.

I specifically chose this example to illustrate a worst case scenario.

Here’s the chart of 30 day Implied Volatility for TSLA over the course of the trade:

Chart courtesy of marketchamelon.com

When you hold an option, you are said to be ‘long volatility’, meaning you stand to gain from volatility increases and suffer from volatility decreases. This applies to options with some time left til expiry.

At, or very close to expiry, the impact of IV on the price of an option is very low (the option’s value will be from its intrinsic value only). At expiry, In-The-Money (ITM) options will be worth the difference between their strike price and the underlying stock price. Out-of-The-Money (OTM) options will be worthless.

TSLA dropping from an IV of 73 to 60 is a 16% drop in IV, and still had plenty of time left til expiry.

While the call option gained intrinsic value as it became more In-The-Money with TSLA’s increasing stock price, any options position also contains extrinsic value, which is affected (primarily) by:

  • Remaining time til expiry
  • Changes to IV

If IV had remained constant at 73, the decrease in extrinsic value due to time (aka theta decay) would have been outweighed by the increase in intrinsic value, resulting in a profit.

With constant IVIntrinsicExtrinsicValue
At purchase0*$63.10$63.10
Theoretical pos.$26.75$41.51$68.26
Difference+$26.75-$21.59+$5.16
Decrease in Extrinsic value due to theta decay (time) only.

*As the option started Out-of-The-Money, it had no intrinsic value, and it’s value was entirely extrinsic.

But as it happened, IV dropped, making the extrinsic value worth less than expected (this effect is known as vega).

With IV dropIntrinsicExtrinsicValue
At purchase0$63.10$63.10
Theoretical pos.$26.75$32.85$59.60
Difference+$26.75-$30.25-$3.50

The drop in extrinsic value exceeded the increases from intrinsic value, resulting in a loss.