Implied volatility in option trading

Implied Volatility - IV.

What is 'Implied Volatility - IV'

Implied volatility is the estimated volatility of a security's price. In general, implied volatility increases when the market is bearish, when investors believe that the asset's price will decline over time, and decreases when the market is bullish, when investors believe that the price will rise over time. This is due to the common belief that bearish markets are riskier than bullish markets. Implied volatility is a way of estimating the future fluctuations of a security's worth based on certain predictive factors.

BREAKING DOWN 'Implied Volatility - IV'

Implied volatility is sometimes referred to as "vol." Volatility is commonly denoted by the symbol σ (sigma).

Implied Volatility and Options.

Implied volatility is one of the deciding factors in the pricing of options. Options, which give the buyer the opportunity to buy or sell an asset at a specific price during a pre-determined period of time, have higher premiums with high levels of implied volatility, and vice versa. Implied volatility approximates the future value of an option, and the option's current value takes this into consideration. Implied volatility is an important thing for investors to pay attention to; if the price of the option rises, but the buyer owns a call price on the original, lower price, or strike price, that means he or she can pay the lower price and immediately turn the asset around and sell it at the higher price.

It is important to remember that implied volatility is all probability. It is only an estimate of future prices, rather than an indication of them. Even though investors take implied volatility into account when making investment decisions, and this dependence inevitably has some impact on the prices themselves, there is no guarantee that an option's price will follow the predicted pattern. However, when considering an investment, it does help to consider the actions other investors are taking in relation to the option, and implied volatility is directly correlated with market opinion, which does in turn affect option pricing.

Another important thing to note is that implied volatility does not predict the direction in which the price change will go. For example, high volatility means a large price swing, but the price could swing very high or very low or both. Low volatility means that the price likely won't make broad, unpredictable changes.

Implied volatility is the opposite of historical volatility, also known as realized volatility or statistical volatility, which measures past market changes and their actual results. It is also helpful to consider historical volatility when dealing with an option, as this can sometimes be a predictive factor in the option's future price changes.

Implied volatility also affects pricing of non-option financial instruments, such as an interest rate cap, which limits the amount by which an interest rate can be raised.

Option Pricing Models.

Implied volatility can be determined by using an option pricing model. It is the only factor in the model that isn't directly observable in the market; rather, the option pricing model uses the other factors to determine implied volatility and call premium. The Black-Scholes Model, the most widely used and well-known options pricing model, factors in current stock price, options strike price, time until expiration (denoted as a percent of a year), and risk-free interest rates. The Black-Scholes Model is quick in calculating any number of option prices. However, it cannot accurately calculate American options, since it only considers the price at an option's expiration date.

The Binomial Model, on the other hand, uses a tree diagram, with volatility factored in at each level, to show all possible paths an option's price can take, then works backwards to determine one price. The benefit of this model is that you can revisit it at any point for the possibility of early exercise, which means that an option can be bought or sold at its strike price before its expiration. Early exercise occurs only in American options. However, the calculations involved in this model take a long time to determine, so this model isn't best in rush situations.

What Factors Affect Implied Volatility?

Just like the market as a whole, implied volatility is subject to capricious changes. Supply and demand is a major determining factor for implied volatility. When a security is in high demand, the price tends to rise, and so does implied volatility, which leads to a higher option premium, due to the risky nature of the option. The opposite is also true; when there is plenty of supply but not enough market demand, the implied volatility falls, and the option price becomes cheaper.

Another influencing factor is time value of the option, or the amount of time until the option expires, which results in a premium. A short-dated option often results in a low implied volatility, whereas a long-dated option tends to result in a high implied volatility, since there is more time priced into the option and time is more of a variable.

For an investor's guide to implied volatility and a full discussion on options, read Implied Volatility: Buy Low and Sell High, which gives a detailed description of the pricing of options based on the implied volatility.

In addition to known factors such as market price, interest rate, expiration date, and strike price, implied volatility is used in calculating an option's premium. IV can be derived from a model such as the Black Scholes Model.

Implied Volatility: Buy Low and Sell High.

In the financial markets, options are rapidly becoming a widely accepted and popular investing method. Whether they are used to insure a portfolio, generate income or leverage stock price movements, they provide advantages other financial instruments don't.

Aside from all the advantages, the most complicated aspect of options is learning their pricing method. Don't get discouraged – there are several theoretical pricing models and option calculators that can help you get a feel for how these prices are derived. Read on to uncover these helpful tools.

What Is Implied Volatility?

It is not uncommon for investors to be reluctant about using options because there are several variables that influence an option's premium. Don't let yourself become one of these people. As interest in options continues to grow and the market becomes increasingly volatile, this will dramatically affect the pricing of options and, in turn, affect the possibilities and pitfalls that can occur when trading them.

Implied volatility is an essential ingredient to the option pricing equation. To better understand implied volatility and how it drives the price of options, let's go over the basics of options pricing.

Option Pricing Basics.

Option premiums are manufactured from two main ingredients: intrinsic value and time value. Intrinsic value is an option's inherent value, or an option's equity. If you own a $50 call option on a stock that is trading at $60, this means that you can buy the stock at the $50 strike price and immediately sell it in the market for $60. The intrinsic value or equity of this option is $10 ($60 - $50 = $10). The only factor that influences an option's intrinsic value is the underlying stock's price versus the difference of the option's strike price. No other factor can influence an option's intrinsic value.

Using the same example, let's say this option is priced at $14. This means the option premium is priced at $4 more than its intrinsic value. This is where time value comes into play.

Time value is the additional premium that is priced into an option, which represents the amount of time left until expiration. The price of time is influenced by various factors, such as time until expiration, stock price, strike price and interest rates, but none of these is as significant as implied volatility.

[ Learn the details of intrinsic value and time value through simple graphics and easy to follow calculations in Investopedia Academy's Options for Beginners course. ]

Implied volatility represents the expected volatility of a stock over the life of the option. As expectations change, option premiums react appropriately. Implied volatility is directly influenced by the supply and demand of the underlying options and by the market's expectation of the share price's direction. As expectations rise, or as the demand for an option increases, implied volatility will rise. Options that have high levels of implied volatility will result in high-priced option premiums. Conversely, as the market's expectations decrease, or demand for an option diminishes, implied volatility will decrease. Options containing lower levels of implied volatility will result in cheaper option prices. This is important because the rise and fall of implied volatility will determine how expensive or cheap time value is to the option.

How Implied Volatility Affects Options.

The success of an options trade can be significantly enhanced by being on the right side of implied volatility changes. For example, if you own options when implied volatility increases, the price of these options climbs higher. A change in implied volatility for the worse can create losses, however, even when you are right about the stock's direction.

Each listed option has a unique sensitivity to implied volatility changes. For example, short-dated options will be less sensitive to implied volatility, while long-dated options will be more sensitive. This is based on the fact that long-dated options have more time value priced into them, while short-dated options have less.

Also consider that each strike price will respond differently to implied volatility changes. Options with strike prices that are near the money are most sensitive to implied volatility changes, while options that are further in the money or out of the money will be less sensitive to implied volatility changes. An option's sensitivity to implied volatility changes can be determined by Vega – an option Greek. Keep in mind that as the stock's price fluctuates and as the time until expiration passes, Vega values increase or decrease, depending on these changes. This means that an option can become more or less sensitive to implied volatility changes.

How to Use Implied Volatility to Your Advantage.

One effective way to analyze implied volatility is to examine a chart. Many charting platforms provide ways to chart an underlying option's average implied volatility, in which multiple implied volatility values are tallied up and averaged together. For example, the volatility index (VIX) is calculated in a similar fashion. Implied volatility values of near-dated, near-the-money S&P 500 Index options are averaged to determine the VIX's value. The same can be accomplished on any stock that offers options.

Figure 1 shows that implied volatility fluctuates the same way prices do. Implied volatility is expressed in percentage terms and is relative to the underlying stock and how volatile it is. For example, General Electric stock will have lower volatility values than Apple Computer because Apple's stock is much more volatile than General Electric's. Apple's volatility range will be much higher than GE's. What might be considered a low percentage value for AAPL might be considered relatively high for GE.

Because each stock has a unique implied volatility range, these values should not be compared to another stock's volatility range. Implied volatility should be analyzed on a relative basis. In other words, after you have determined the implied volatility range for the option you are trading, you will not want to compare it against another. What is considered a relatively high value for one company might be considered low for another.

Figure 2 is an example of how to determine a relative implied volatility range. Look at the peaks to determine when implied volatility is relatively high, and examine the troughs to conclude when implied volatility is relatively low. By doing this, you determine when the underlying options are relatively cheap or expensive. If you can see where the relative highs are (highlighted in red), you might forecast a future drop in implied volatility, or at least a reversion to the mean. Conversely, if you determine where implied volatility is relatively low, you might forecast a possible rise in implied volatility or a reversion to its mean.

Implied volatility, like everything else, moves in cycles. High volatility periods are followed by low volatility periods, and vice versa. Using relative implied volatility ranges, combined with forecasting techniques, helps investors select the best possible trade. When determining a suitable strategy, these concepts are critical in finding a high probability of success, helping you maximize returns and minimize risk.

Using Implied Volatility to Determine Strategy.

You've probably heard that you should buy undervalued options and sell overvalued options. While this process is not as easy as it sounds, it is a great methodology to follow when selecting an appropriate option strategy. Your ability to properly evaluate and forecast implied volatility will make the process of buying cheap options and selling expensive options that much easier.

When forecasting implied volatility, there are four things to consider:

1. Make sure you can determine whether implied volatility is high or low and whether it is rising or falling. Remember, as implied volatility increases, option premiums become more expensive. As implied volatility decreases, options become less expensive. As implied volatility reaches extreme highs or lows, it is likely to revert back to its mean.

2. If you come across options that yield expensive premiums due to high implied volatility, understand that there is a reason for this. Check the news to see what caused such high company expectations and high demand for the options. It is not uncommon to see implied volatility plateau ahead of earnings announcements, merger and acquisition rumors, product approvals and other news events. Because this is when a lot of price movement takes place, the demand to participate in such events will drive option prices higher. Keep in mind that after the market-anticipated event occurs, implied volatility will collapse and revert back to its mean.

3. When you see options trading with high implied volatility levels, consider selling strategies. As option premiums become relatively expensive, they are less attractive to purchase and more desirable to sell. Such strategies include covered calls, naked puts, short straddles and credit spreads. By contrast, there will be times when you discover relatively cheap options, such as when implied volatility is trading at or near relative to historical lows. Many option investors use this opportunity to purchase long-dated options and look to hold them through a forecasted volatility increase.

4. When you discover options that are trading with low implied volatility levels, consider buying strategies. With relatively cheap time premiums, options are more attractive to purchase and less desirable to sell. Such strategies include buying calls, puts, long straddles and debit spreads.

The Bottom Line.

In the process of selecting strategies, expiration months or strike price, you should gauge the impact that implied volatility has on these trading decisions to make better choices. You should also make use of a few simple volatility forecasting concepts. This knowledge can help you avoid buying overpriced options and avoid selling underpriced ones.

What is Implied Volatility?

Implied volatility is the market’s estimate of how much a security will move over a specific period of time. Generally implied volatility is related in percentage terms and is a reflection of a securities potential movement on an annualized basis. Implied volatility is used in many formulas such as the Black Scholes options pricing model as well as VAR to assist in valuing securities and evaluating risk.

Volatility is a measurement of how much a security has changed on a historical basis and is calculated using the standard deviation of the security over a specific period of time. Implied volatility is the markets estimate and is driven by market participants.

Implied volatility is one of the major inputs used by traders to price premiums for binary options. Since an option is the right but not the obligation to purchase (or sell) a security at a certain price on or before a specific date, it is priced by how likely it will be in or out of the money by a specific date. The likelihood is based on the current price, the strike price, current interest rates, and an estimate of how volatile the security is at the current time. This likelihood is expressed in terms of implied volatility.

For example, if a security has an implied volatility that is 20%, a strike price that is only 5% away will likely be reached in 1 year and therefore the premium will reflect that likelihood. If the implied volatility on the other hand is 5% and the strike price is 20% away, the premium will be lower based on the idea that it is unlikely the stock will be above (or below) the strike price.

High levels of implied volatility reflect a market condition where fear is prevalent and traders believe that a security will move violently, while low levels of implied volatility reflect a market condition where complacency is dominant.

To track the potential direction of implied volatility, investors use historical implied volatility and chart its path similar to the way they would chart a security when financial trading. The most popular index which tracks implied volatility is the VIX volatility index.

The VIX volatility index measures the implied volatility of nearby S&P 500 at the money options. The VIX trades as a futures contract, as well as in an ETF format. The VIX can be used to hedge a portfolio that is similar to the S&P 500 index as premiums for option generally increase during adverse changes to a stock index. For example, the VIX will generally climb as the S&P 500 moves lower, and declines as the S&P 500 moves higher.

When purchasing options, an investor should understand that what he or she is really purchasing or selling is the chance that a security will be in or out of the money. This chance is priced by professionals, and most options expire out of the money. With this in mind, an investor should chart volatility on a graph when considering a purchase and determine if the current level of implied volatility is rich or cheap.

Key Concepts 1. Probabilities & Statistics.

Implied Volatility.

Implied volatility (commonly referred to as volatility or IV ) is one of the most important metrics to understand and be aware of when trading options.

What does “one standard deviation” mean?

In statistics, one standard deviation is a measurement that encompasses approximately 68.2% of outcomes. When it comes to IV, one standard deviation means that there is approximately a 68% probability of a stock settling within the expected range as determined by option prices. In the example of a $200 stock with an IV of 25%, it would mean that there is an implied 68% probability that the stock is between $150 and $250 in one year.

Why is this important?

Options are insurance contracts, and when the future of an asset becomes more uncertain, there is more demand for insurance on that asset. When applied to stocks, this means that a stock’s options will become more expensive as market participants become more uncertain about that stock’s performance in the future.

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