Lean In, to Implied Volatility

Dmitry Pargamanik and Will McBride, the cofounders of Market Chameleon, join IBKR’s Jeff Praissman to discuss the effect that implied volatility can have on option quotes and how traders can use this to their advantage.

Summary – IBKR Podcasts Ep. 198

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman 

Hi, everyone. My name is Jeff Praissman with Interactive Brokers. It’s my pleasure to welcome back to our IBKR Podcast from Market Chameleon, Dmitry Pargamanik and Will McBride. Hey, guys, how are you? 

Will McBride 

Hey, Jeff. Thanks for having us. 

Dmitry Pargamanik 

Thanks for having us, Jeff.  

Jeff Praissman 

Always a pleasure to have you guys for our monthly podcast. And we just finished up a great webinar on implied volatility leans and option quotes. And we wanted to, as we usually do, just take a little bit of a deeper dive or maybe even a different dive into the subject in our podcast studio. 

And if we could kick it off just for our listeners, could you guys just define implied volatility, just going to start from square one? 

Dmitry Pargamanik 

Maybe a simpler way to look at implied volatility is it’s a relative value that is derived from an option pricing model. And what it’s useful for is if we look at options in general, a stock will have many different options. It will have different strikes, different expirations, calls and puts. 

And how do you compare these options? You would need some kind of relative value. Similarly, if you have two stocks, one is $10.00, one is $100.00, but to compare them, maybe you get a P/E ratio and then you get a relative value to compare which one is more expensive or less expensive relative to a P/E.  

So in the implied volatility, that’s what it allows us to do is convert the option prices into A relative value, what would that implied volatility be if you plug it into the option pricing model? Just much quicker comparison and a much easier way to look and evaluate the options on a relative value basis. 

Jeff Praissman 

What we talked about in the webinar was the implied volatility leans in the option quote.  

So now I want to take the quote. Most people know you have a bid and an ask, but I’m curious, what’s involved? Is it always just a single dealer producing that quote? 

Or does it come from multiple sources? Or, how does that quote evolve? 

Dmitry Pargamanik 

Yeah. And that’s a good question. A lot of customers compare the bid and offer, and then look at the last trade where the bid and offer was at the time and assume if the trade was on the ask side of the offer, then an incoming order bought it from a dealer, let’s say, or if it’s on a bid, they sold it to a dealer. 

And the quote itself. We call it the National Best Bidding Offer, NBBO. It’s not only made up of a dealer quote, like a specialist, or lead market maker obligated to always create a bidding offer. But there are also other market makers that could be involved improving that quote or one side of the quote. 

And it also includes any resting orders or limit orders or special orders from retail traders. 

So a quote can consist of two retail traders, one on the bid side, one in the offer, and the dealer quote could be outside those markets. Or it could be on one side of the trade where you have a dealer that’s bidding, but you have another limit order that improved the ask. 

And then they become the MBBO or the offer. So the quote itself is not made up of only dealers. It’s any market participant that could enter in an order. And if that order is either the best bid nationally or the best offer, it’ll get displayed as part of the quote. 

Jeff Praissman 

And then you could also have multiple dealers or market makers on a side of the quote as well, or both sides. In other words, if it’s a $1.20, you could have multiple people that are at a $1.20 and multiple, maybe even different people that are at $1.00 a bid, correct? 

Dmitry Pargamanik 

Exactly. So it could be dealers, other market makers, specialists. It could be proprietary traders and retail traders all bidding at the same price that make up that size of that bid. 

Jeff Praissman 

Yeah. So now that we’ve defined the implied volatility and also gave our listeners what’s involved with the quote, I’d like to really get into the meat of the subject here. So what exactly is an implied volatility lean in option quotes? 

Dmitry Pargamanik 

So when we look at an option quote, we get a bid and an offer, and sometimes that quote itself can have a limit order. Like we said, like a resting order or a market maker steps up or steps down and squeezes the market. But to really detect that, to try to detect it, what we could use is the implied volatilities that are available to us and look for a lean where the implied volatility looks like it’s squeezing the market, on the offer, on the bid side, or on both sides. 

That’s what the lean is looking at and it does it on a relative basis because if we could look at the implied volatilities of the surrounding options and the spreads of the surrounding options, sometimes we could just detect that yes, looks like there’s a lean on the ask side because that relative implied volatility is much lower than everything we’ve seen in the surrounding options. 

Or a lean on the bid side would squeeze in the market on the bid. Again, by comparing the surrounding markets. So that’s where we could use the implied volatilities and detect a lean, either on one side or both sides of the market.  

Jeff Praissman 

And what can that lean indicate as far as.. with our podcasts and your webinars, a lot of it centers around data and using data to become a more educated trader and deciphering that data. How can these leans be used by investors and traders to make informed or intelligent decisions? How can they utilize these leans and that information? 

What are some of the uses? 

Dmitry Pargamanik 

Right. first, what can it indicate? What is an implied volatility? If you detect it, what can it indicate? And one is that there may be interest on one side of the market that somebody is improving that market to try to get an execution. Maybe they’re not fully ready to just go and take out the bid or the offer, or maybe they have more than just, they’re looking to bring in somebody to trade with that could trade in more size or at better prices. 

So by improving the market and displaying it, you’re signaling to the market I’m on this side willing to improve or buy at a potentially better price.  

And it could indicate maybe there’s just a resting order, a limit order, where the market is moving. 

Let’s say there’s a limit order to sell a call option. That limit order could have been placed an hour ago, two hours ago, but it was far away from the market. But if the stock is moving higher and the market gets closer to it, at some point, it could show up where there is a resting order on the book, the market’s moving closer to it, not quite enough to take it, but it’s a potential to detect something like that. 

Or it could indicate where just a dealer is trying to trade it for a certain option from a certain side. And he’s telecasting it to the market, or it could be a trader, who has access to a special order type of pegged order. So you could put in, in order instead of a price, you could put in implied volatility order where you say I want to try to buy this implied volatility or sell this implied volatility. 

And what will happen is that order would have to be pegged to the stock price.  

Because every time the stock price changes, you’d have to recalculate that new implied volatility. And that will move up and down with the market because you’re just trying to execute a certain implied volatility instead of a certain price. 

Those are the things that implied volatility could indicate is existing in that market. 

Jeff Praissman 

Yeah. I’m assuming another common theme of our discussions when we’re talking about data and deciphering it. There seems to always be other factors that the investor can use along with whatever the specific data we’re talking about to help decipher the information, dig down a little bit deeper, do another layer. 

What are some of the other factors that people can use along with this implied volatility lean? 

Dmitry Pargamanik 

Yeah when we look at traders, a lot of traders try to analyze the trading activity and the trading volume, and they try to paint themselves a picture of what might be going on. And you can’t always tell what goes on, but sometimes you have enough information to make a very good inference. 

So for example, if we’re looking at an implied volatility lean and we see a lot of trading, let’s say there’s an implied volatility lean on a specific option on the bid slot, and we see a lot of trading there and maybe we combine that with like open interest where there’s zero open interest at the start of the day. 

That could indicate that somebody has a pretty active bid out there and their intent is to build up a long position in a certain option. And we see them doing that throughout the day where, you know, different trades are occurring on the bid. And then we could look the next day to confirm that. Did the traded volume convert to a new, open interest, for example?  

Or we could look at the other way and say there’s somebody sitting on one side of the market. It looks like it’s trading a lot, but the next day, we see a big decrease in open interest. That may be somebody that is exiting a position or closed out of a position and they were just improving the market.  

So by combining different pieces of information, it’ll help you get maybe a better picture of what may have been going on in that trading activity? 

Jeff Praissman 

In your last couple answers, you’ve definitely touched on the benefits, but maybe if you could just recap them for our listeners. Certainly information is clearly a benefit, but if you maybe just summarize them for our listeners, just so it’s clear what some of the potential benefits are. 

Dmitry Pargamanik 

When you’re looking at it, if you have a system that could detect these leans, then you could quickly just open up an options chain and see where the leans are. Which options are indicating an implied volatility lean? And of course, that gives you more information about where you might be able to trade with somebody that’s willing to improve the markets, for example, and you could see what they’re indicating, on which side of the market they’re indicating they’re interested in. And it could be on both sides. Sometimes you’ll see a squeezed market on both sides, people willing to trade a certain option on both sides. 

And also, it helps detect where, on a relative basis, there’s a tighter spread.  

So as a trader, you’re always trying to get a better execution and to get a better execution you want to be able to get basically a better price where the markets are tighter, where the spreads are tighter. 

That’s where you could get a better execution than if the things are wider. 

So the tighter the markets are the closer they are to the market fair value. And that’s where you would want to probably look at if you were trying to get a better execution in a particular option. 

Jeff Praissman 

And, that’s obviously a way the investor can take advantage of that lean by getting that better execution. Are there other ways, maybe, any kind of strategies or combos or?  

Dmitry Pargamanik 

Yeah, for a single leg, if you’re just looking for, let’s say you’re looking to maybe do a call option, right? So it’s either going to be like around at the money or out of the money. And you’d want to look at strikes that are close and then you could just tell where on a relative basis, oh this particular strike, there’s an implied volatility lean on a bid. 

So I might be able to get a better execution on this strike where, the strikes can be very close together. 

Or even buying an option, the same thing where you could spot really quickly, here’s a place where I might be able to sell an option for a better price or buy one. Another way is a strategy, maybe, necessarily, you are looking to sell an option that’s not part of your strategy just to sell it. But if you do look at an option and you say you know what, if I would spread it off and if I could scan, even within the same options chain where I could perhaps buy an option that has an implied volatility lean on ask and sell an option on with implied volatility on the bid side on a relative basis, I could spread into them and execute a good spread, right? 

So that’s another way where you could do a horizontal spread or a vertical spread, but you’re doing it by looking where are the potential places where you could execute those trades for a price that makes sense to you, that looks like you have some sort of trading edge or trading advantage. 

Jeff Praissman 

Dmitry, this is great. Any final thoughts you want to leave the listeners with before we sign off? 

Dmitry Pargamanik 

Yeah, I think when you’re looking at trading and you’re looking at potential options or potential spreads, and you’re trying to see where perhaps you could get a better execution, maybe some trading edge, take a look at those implied volatility leans, because those could really improve your trading. 

It’s something to consider, when you’re looking at an options chain or a particular strategy that you’re trying to execute or an option. 

Jeff Praissman 

Ah, great. Again, great webinar, great podcast. For our listeners, for more information, for more material from Market Chameleon, you can go on our website, go to Education, look for Contributors. You can find all the great podcasts and webinars that Market Chameleon has produced with us. 

They also run a morning show every morning on YouTube. And as always guys, it’s been a pleasure and I’m looking forward to having you guys back in the studio next month. 

Dmitry Pargamanik 

Great. Thanks, Jeff.  

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