Option implied volatility and theoretical volatility

When implied volatility is substantially higher than theoretical volatility, does it mean option is overvalued, and is it good time to sell the option?

Volatility and price are correlated, thus artificially high volatility implied by the option price means the market price exceeds intrinsic value. Sell it.

Thank you. Even though the CFA exam is over, we continue to learn.

Correlated?

Ick.

Perhaps you mean that they have a direct relationship.

Yes.

(I assume that by theoretical volatility you mean _ expected _ volatility.)

And yes.

(I assume that by theoretical volatility you mean _ expected _ volatility.)

yes, i think they are the same, or forecast volatility.

Could be correlated, no? I’d think if volatility is above its mean, then price of a call or put would too. Idk though, never looked.

Of course theres other variables that impact options other than volatility of course. That’s why I’m not sure…

That depends on what you mean when you say that they’re correlated.

Does having a correlation of +1.0 constitute being correlated?

How about a correlation of +0.8? Or +0.2? Or −1.0? Or −0.7? Or −0.1?

True. Positively correlated but I have no idea to what degree.

That’s the problem with ambiguous adjectives such as “correlated”.

That’s not your fault, of course: finance people the world over say stuff like that. And most of the time they have no concrete idea what they mean by it.

Direct relationship also does not tell you anything about the details or nature of the relationship. Does it mean +1.0? -1.0? It’s equally ambiguous.

I should have said (and meant to say) “positively correlated”. Didn’t think it was worth an edit and still don’t.

Direct in the sense of increasing together or decreasing together. As opposed to inverse: one increases when the other decreases.

How about this: “The partial derivative of the option value with respect to the volatility of the price of the underlying is positive.”?

It means +something; i.e., positive.

Except that it’s not.

It’s positive, not negative.

Which directly answers the original question:

Feels nit picky. I’ve already said it would have been more correct if the correlation being positive was explicitly stated, but in the absence of contradictory information most rational people would reasonably determine the correlation was positive. If the graders parse words in this manner then I’ll just take my fail and skip the retake

I’m not sure that I follow what you’re saying.

Are you saying that, in general, if someone says “A and B are correlated” most rational people (who don’t know the relationship between A and B) would “reasonably determine” that the correlation is positive? If so, on what basis will they do that (given what they don’t know)?

If that’s not what you’re saying, then please review the original question. OP clearly didn’t know the relationship between the A (the difference between implied volatility and expected volatility) and B (the difference between the market price of the option and the fair price of the option).

There’s a strong, positive correlation between being a good teacher and understanding what your student already knows (and, what your student doesn’t know). That’s the point, and it’s head and shoulders above nitpicking.

They will I’m sure. Saying something’s simply correlated may not get you full credit.

[quote=“S2000magician”]

In normal discourse/conversation, yes, correlated is usually/almost always interpreted to mean positively correlated. And that if things are negatively correlated, you would need to say negatively correlated to be clear. Just like when I say 7, I mean positive 7, but if I’m on the other side of 0, I say negative 7. (and no one blinks an eye or gets confused)

Of course when people use the word or in normal conversation, they mean exclusive or, not logical/mathematical or. So I can see how if you are a very rules based/factual person it could be confusing. A lot of things in normal conversation are understood based on context and precedent. (and can vary based on culture, situation, etc.)

[quote=“Candidcam”]

Well stated.

[quote=“Candidcam”]

It’s not remotely just like saying 7 to mean positive 7.

Nontechnical people know what 7 and −7 mean; I suspect that nontechnical people, by and large, do not know what correlated means.

And in normal discourse/conversation, I suspect that most people have absolutely no idea what “correlated” means. To conclude that most people usually/almost always interpret it to mean positively correlated would, at the very least, require some evidence. Have you conducted a poll?

All of this notwithstanding, OP clearly didn’t understand the relationship. To try to explain it with what is, at best, an ambiguous term is poor strategy. We’re supposed to be helping candidates here; we do that by being clear, and unambiguous. That, as I mentioned earlier, is the point.

[quote=“googs1484”]

Except for the “Just like . . .” part.