Option Trading Blog

Before you start yelling at me and tell me how can I say they are not good investment if I myself trade them, let me explain what I mean by that. It is true that I trade options, but only for short term trading. I usually get rid of my options in the same day. Let us consider the situation where a person thinks a stock should rise in value in the future. Instead of buying the stock itself, he wants to buy a call option on the stock. A person might do this because of the leverage an option provides.

Some Option Drawbacks

It is true that options provide leverage that can boost profits. The problem is that, unlike a stock, they can lose value pretty quickly and even if the move you waited to happen has happened, you might not profit from it.

Losing Value With Time

Unlike a stock, the option loses value with time. Intuitively, this is because the option has less probability to finish inside the money as time progresses.

Losing Value If Implied Volatility Changes

Lower implied volatility means less chance that the option will finish inside the money, hence causing it’s price to decline.

The above should be a reminder on how NOT to trade options. You don’t buy an option to sit back and look how the option rises in value.

Some Exceptions

Exceptions naturally occur when you use options as hedging tools in conjunction with stocks. Buying a stock and buying a
put is a fairly good idea for the risk averse investor.

There are several programs out there that purport to give you an accurate picture of the implied volatilities. Sadly, some of them are not accurate at all. I had put up a nice(?) program I wrote in Matlab to compute the Implied Volatility of options on a set of strikes. The good thing about the program is that it computes the implied volatility for several strikes and price and not individually. Also, it is very accurate. You specify the yearly rate of return, the yearly dividend yield(if any) and the underlying price. You can put the strikes and their respective prices in an excel file. The first column would be the strike prices and the second column would be the prices. Leave the third column empty. This is where the program will write the implied volatilities. You can also plot the implied volatility smile or skew.

Here is a screen shot to give you an idea:

How Does it Work

First, you make a an excel sheet. In the first column write the Strikes. In the second, write the prices for the respective strikes. This should like something like this:

After you have this file. Specify if you are computing for a call option or a put option in the check box. Make sure you only chose one unless you want to drive my program crazy! Then specify the current underlying price, the time to maturity (you can chose to write it in either days, months or years just make sure you check the right radio button)

Make sure you put in the rate the yearly interest (0.04 is 4% yearly interest. So make sure you put a decimal number there). For the dividend yield, this is the yearly compounded dividend yield of the stock/index. It should be a decimal number. If you don’t know what it is, it’s best to put 0 there.

Importing Data

After you are done, press the import data and chose the excel file you had made. Click on it and voila. It’ll write in the 3rd column the respective implied volatilities:

Plotting the graph

After all that, you can plot the graph of the implied volatilities against the strike prices. The green dots is the data and the blue line is the interpolated data. This should give you an idea of how the implied volatility look likes. It is generally sloping downward.
For information about why check out the post about the volatility smile. I intend to add many more features to it in the future. I want to also add the implied risk neutral distribution and many more nice things. So stay tuned about that. If you have anymore things you’d like to see in there (which are feasible of course) tell me. I’d be happy to have feedback.

Download

Here is the downside: This was written in Matlab. When I checked to see how this can be distributed to people without Matlab, I had discovered that you have to install first some (very?) big file which is 76 mbs. It is called MCRInstaller. But after you install this once, you can load any program that was compiled in Matlab. I intend to add many more features to the program which will make it a nice cool freeware for you to use so if you got some patience, be my guest and download it.

After you have downloaded this file, you can download the Implied Volatility Calculator. It is only 3 mbs so it’ll be a piece of cake now.

I’d appreciate any comments and suggestions for later upgrades.