Trading VIX Derivatives – Trading and Hedging Strategies Using VIX Futures, Options, and Exchange Traded Notes : [PDF Download]

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“The implied volatility component of option prices is the factor that can give all option traders, novice to expert, the most difficulty. This occurs because the implied volatility of an option may change while all other pricing factors impacting the price of an option remain unchanged.

This change may occur as the order flow for options is biased more to buying or selling. A result of increased buying of options by market participants is higher implied volatility. Conversely, when there is net selling of options, the implied volatility indicated by option prices moves lower. Basically, the nature of order flow dictates the direction of implied volatility.

Again, more option buying increases the option price and the result is higher implied volatility. Going back to Economics 101, implied volatility reacts to the supply and demand of the marketplace. Buying pushes it higher, and selling pushes it lower. The implied volatility of an option is also considered an indication of the risk associated with the underlying security.

The risk may be thought of as how much movement may be expected from the underlying stock over the life of an option. This is not the potential direction of the stock price move, just the magnitude of the move.

Generally, when thinking of risk, traders think of a stock losing value or the price moving lower. Using implied volatility as a risk measure results in an estimation of a price move in either direction. When the market anticipates that a stock may soon move dramatically, the price of option contracts, both puts and calls, will move higher.”

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