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The term structure of options is used to describe differences in the implied volatility of different options with the same strike price and different terms. In the context of options, volatility always refers to a specific term. Due to the different length of the term, different fluctuations of the underlying asset are expected.
With longer maturities there is more time for the underlying asset to take significant swings up or down. For example, market changes and the resulting increase in volatility in two or three months have no effect on an option that has only a short maturity.
No linear relationships
Despite the same strike comes, there are therefore different implied volatilities. However, it is by no means the case that the implicit volatility develops linearly with the length of the remaining term. Rather, each underlying asset has its own dynamics and is exposed to different market events. The valuation of the maturity structure can therefore only be carried out for a specific underlying asset.
The objective associated with the options determines the term
Conversely, it cannot be claimed that there is an optimal residual term for options. Rather, it depends on what the objective associated with the options is. The appropriate remaining term for options is also based on this objective.
If, for example, you want to hedge a certain stock value in your portfolio against an event that is due next week, you are more likely to buy options with a short remaining term to maturity and buy the lowest possible option price.
On the other hand, if you are speculating on a decline or rise in a price in the near future, for example in the next six to eight months, you will buy options with a correspondingly longer remaining term to maturity.
When selling options, the implicit volatility, above all an increasing volatility, is of particular importance. When volatilities fall, the risk for the option seller is not too great. The time value expiration works for the option seller.
Initial situation decisive
If volatility is very low, there is a possibility that it may increase very sharply. Option sellers could argue that in this situation long-dated options have a very high time value. They would then receive a comparatively high premium and decide to bet on long-term options. Although this is initially true, the option price is particularly sensitive to market changes and a sharp increase in volatility.
Anyone who wants to or has to buy back the put option later has a problem. Particularly long-dated options cannot be “extended” at will in order to “iron out” the effects of unfavourable market developments by betting on a subsequent decrease in volatility. The customary options are limited to maximum terms of one to two years. Option sellers should tend to sell short-dated options than those with low volatilities.
This is associated with lower fair values and thus premium income. If the implied volatility now increases within the remaining term, the end of the term can still be postponed and the resulting risk can be counteracted.
If volatility is currently very high, however, long-term options should be sold because the options are very expensive, which generates correspondingly high premium income. There is a high probability that the volatility will decrease again. Even a repurchase of the options could therefore still be clearly profitable.
Review Implied volatility
The implied volatility describes the expected fluctuation margin over the remaining term of the option. The historical volatility, on the other hand, describes fluctuations within a past period that has already ended.
In addition to the price of the underlying asset, strike price and the interest rate prevailing on the market, the implied volatility plays a decisive role in price formation. If the underlying asset is relatively stable and has low implied volatility, demand falls and with it the option price. The reason is that investors do not see a large profit potential within the remaining term of the option due to low fluctuations.
Read my other articles about options:
- Bear Call Spread Options Strategy
- Bull Put Spread – Earn Money With Puts And Limit Risk
- Butterfly Spread Options Strategy
- Definition Of Option Price/Option Premium
- Earn Money With A Covered Call Options Strategy
- How to exercise Options
- How to use the Standard Deviation for Options Trading
- Iron Condor – Profit From Low Price Fluctuations
- Options Trading Tutorial for beginners
- Options vs. Futures – Two Different Types Of Futures Contracts
- Options vs. Warrants – 4 Differences
- Protective Put – Hedging Of Equity Positions
- Simple Trading Strategies for Options
- Term structure options
- What are options? – Explained Simply And Quickly
- What is a Long Call in Options Trading?
- What is a Long Put in Options Trading?
- What is a Short Call in options Trading?
- What is a Short Put in Options Trading?
- What is delta in Options Trading? – The Most Important Key Figure
- What is Historical Volatility in Options Trading?
- What is the Gamma in Options Trading?
- What is the Implied Volatility Of Options – Important Or Not?
- What is the Theta in Options Trading?
- What Is The Vega Of An Option?