Implied Volatility in Options Trading
Implied volatility is a metric that shows the market’s view of the probability of changes in a security’s price. It is used by investors to project future demand and supply. They often use it to price options contracts.
What does it indicate?
Implied volatility indicates the market’s forecast of a probable movement in the price of a given security. It is often employed to price options contracts. Options with high IV have higher premiums and conversely, options with lower IV have lower premiums. It is denoted by σ (sigma).
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Factors affecting Implied Volatility:
- Demand and Supply: Demand and supply are the major factors influencing implied volatility. As the demand for an asset increases, its price rises along with its implied volatility. This leads to a higher option premium because of the riskiness of the option. Conversely, as the demand falls with an excess supply, the IV falls and with it the options price gets low.
- Time value: The time value of an option or the amount of time until the expiration of an option, is another factor that influences the option’s premium. An option with a shorter maturity will often ensue with a low IV and an option with a longer maturity often results in a high IV. This is because of the longer time period, the price has more time to move into a favorable price level as compared to the strike price.
How can traders use Implied Volatility in Options Trading?
Traders can use implied volatility to see the market’s forecast of the likelihood of the volatility of the security’s price. IV usually increases in bearish markets that is when investors think prices will decline. In contrast, IV decreases in bullish markets as the investors think that prices will rise. Traders can use IV to gauge the market’s sentiment. When the options have high implied volatility, traders are more likely to sell the options as the option premium price increases. Some selling strategies include covered calls, short straddles, credit spreads, and naked puts. In contrast, traders are less likely to sell when the options have lower IV due to cheap premium prices.
Importance:
IV helps us understand and quantify the market sentiment. It measures the size of the movement of an asset. However, implied volatility does not show the direction in which this movement will take place. So, the asset can increase or decrease. IV is used to price options. It also helps the investors decide whether to buy or sell the options. During high volatility periods, investors generally choose to invest in safer sectors. IV gives traders a general range of prices that an asset is expected to swing between. It also helps to understand good entry and exit points.
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Conclusion:
Implied volatility is an important tool that quantifies the market’s sentiment. It is used to set option prices. IV offers the range of movement of an asset’s price and not the direction in which it is heading. Demand and supply are the major factors that affect implied volatility.
Author – Abha Shetty
About the author – Abha is a second-year BMS student and FRM level 1 candidate. She is very intrigued by the world of financial markets and hopes to master the art of investing and trading.
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