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Does IV increases when option gets towards expiration?
I've been trying to observe something, but can't find evidence, needs somebody who has better knowledge than myself to answer if possible please. This applies to ITM/ATM and OTM
Trading: Equities, index options and futures/futures options
Posts: 190 since Apr 2010
Thanks Given: 66
Thanks Received: 198
IV is a measure of how much movement the marketplace expects in the underlying between now and expiration. It is derived from the price of the option especially the extrinsic or time value component of that price. Normal conditions in equity markets produce a term structure where IV increases with time when all other factors remain the same. Chaotic markets can produce term structures where shorter term options have higher implied volatilities than longer term options. Vega which measures option price sensitivity to volatility normally increases with time to expiration. Gamma which measures option Delta sensitivity to movement in the underlying normally increases as the option gets closer to expiration.
(Edited this a bit)
While time is a component of IV, it's not the only component.
The passage of time guarantees a narrower (higher kurtosis) probability distribution, simply because time must pass, and with each passing minute, that's one less minute that the price will be able to go towards the tails.
However, imagine an option that expires the day before a major event (election, etc.). Perhaps events leading up to that event will cause IV to increase. After a few days, some relief in news comes such that there's not much perceived risk. IV will decrease. However, then something else causes concern. IVs increase.
This is a massive oversimplification, and I'd love to get some clarity from someone who knows a lot more about this than me!
@Bookworm provided a good answer but I would add that it has more to do with upcoming catalysts and events. You need to look at the option strike IV as well as the 30 day means. Certain active strikes will have higher IV's than other strikes. If the model is showing 30% volatility that doesn't mean that currently the option is being valued at that same percentage. It is always dynamic and traders are reflecting and thus implying that a move (bigger ranges) will happen in the future but willing to pay more for it today warranting even higher IV. Understanding Intrinsic and Extrinsic value is important which is simply the ITM portion of option, if any, and Time. This will help since the extrinsic value is wholly determined by the volatility. Extrinsic value can change big from yesterday to today based on Volatility going in or out because of news; a volatility pop or crush. The shift in Value from Extrinsic to Intrinsic. If there's anything, never buy (long) options with high IV. Consider Credit or Debit spreads.
