Hi cerhob, Nice to hear from you again. Ive been away awhile. Yes a MM will use Hist vola to calculate his spread. As a seller, he wouldn’t bother checking imp vola. As a buyer, we should keep an eye on imp vola. So with any pricing model, you have one or the other. In other words, when you use hist vola, you get the fair value of the call and know what you should sell for. When I take the price of the last trade, and put that into the pricing model, it works backwards and tells me what the volatility would have to be to get a fair price at the last trade, and we call that implied volatility. So using a real example, the hist vola of tls might be 21%, but the prices mugs are paying for calls, is making the statement; "I think tls’s vola is really 25%". So 25% would be the impl vola.
As we can only calculate vola backwards (historic) we have no idea what the vola of a stock will be between now and expiry, and so we use imp vola to solve the problem. It’s a measure of what traders think wil happen to the vola in the future.
When I say Iani payed too much, Im implying he should have set his buy price at a certain level (using the vola value he wanted) and not traded until the price came to him. MMs speak in terms of volatility. They say "that guy just paid 30% imp vola!" How often have we all bought a call, only to see the price go up a little, but the call price drop as vola falls? Mugs think (not you Iani, mate, but Im talking in general) they only have to get the price direction right, and they become fodder for the beast, and say the MM ripped me off. At least iani has the honesty to ask, did the MM rip me off, or did I miss something that I can learn from?
A better strategy would have been to chart the volatility, and sell the straddle, if he thought vola was falling, or buy the straddle if he thought vola was rising. Read the threads Ive had with rembrandt over the last few weeks for more info.
