In regards to option prices, what's the difference between implied volatility and simple supply and demand?

Question

According to MCMILLAN ON OPTIONS, implied volatility always drives options prices higher. He doesn't even list supply and demand as a factor influencing option prices. But let's say the VIX index is at 10, and we know that the index rarely goes below 10 and rarely stays at 10 for long. Supply and demand will drive up the price of long VIX calls and drive DOWN the price of short VIX puts. Implied volatility, in this case, would make PUT prices LOWER, not higher. Implied volatility obviously drives supply and demand, but it can make prices higher or lower (contrary to what the options expert McMillan says), depending upon whether there is more (or less) upside potential in comparison to downside potential. Am I getting this right or not? Is this so obvious that McMillan doesn't even mention it? Or am I missing something?

Answer 1

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Higher implied volatility (IV) by definition drives option prices higher.

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Supply and demand, for all practical purposes, determines the IV. However, "supply and demand" is not a variable in any of the option models.

It is sort of like if I asked you how much it would cost you to fill your gas tank if it was was empty the formula would be (the capacity of the gas tank) multiplied by (the cost per gallon). The cost per gallon is determined by supply and demand, but is not part of the formula to determine the cost of filling your tank.

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Using VIX as an example confuses the issue because you have two different IVs involved. The value of VIX is the IV for S&P 500 index, and measures how much the value of the S&P 500 index is expected to go up or down. The IV of VIX measures how much the value of VIX is expected to go up or down. In other words, the IV of VIX is the expected volatility of the implied volatility of the S&P 500 index.

So, while you are correct that if the value of VIX (the IV of the S&P 500 index) goes up puts on VIX decrease in value, this is due to a change in the delta of the options on VIX. What McMillan is saying, correctly, is that if the IV of VIX goes up it will make both calls and puts on VIX more expensive due to vega.

All this brings us back to your original question:

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Supply and demand creates changes in IV.

It should also be noted that IV must be kept relatively close between different options with the same underlying or risk-free arbitrage situations will occur. For example, no matter how many buy orders there are for January calls on XYZ and no matter how many sell orders there are for April calls on XYZ, the price of a January call at a given strike cannot exceed the price of an April call at the same strike. If it did, anyone could buy the April calls and sell the January calls for a risk free credit.

Answer 2

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Answer 3

Implied vol is the measure of supply/demand