CFA, FRM

Implied Volatility – How Traders use it

What is Implied Volatility (IV)?

The option premium is made up of two basic components I.e. Intrinsic value and time value. Intrinsic value is influenced by the underlying spot price against the option’s strike price. Time value is an additional premium which option buyer pays and it keeps on declining as expiration date comes closer. The price of time value is influenced by multiple factors such as the time until expiry, interest rates but it is majorly influenced by implied volatility.

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There are two basic forms of volatility:

  • Historical volatility and implied volatility. Historical volatility is “the annualized standard deviation of stock price movements”. In simple terms, it can be said as how much stock price fluctuated on the day to day basis in the past one-year period.
  • IV is the expected volatility of the underlying instrument until the expiry of the option contract.

There are multiple factors that impact implied volatility. Two major influencers can be Volumes and Time to expiry.

Volume: If the volumes of options increase, its implied volatility will increase which in turn will increase the option premium. Conversely, as the demand decrease and volumes reduce, implied volatility will decrease which results in cheaper option prices. Lower implied volatility means the price of an option will fall. The time value of an option becomes cheaper or expensive depending on the fall or rise in IV.

Time to expiry: For shorter duration options, there may not be huge fluctuations in the underlying instrument. Hence they are less sensitive to IV longer duration option contracts.

The IV is high when the expected movement is huge and vice versa. This expected volatility may be higher due to a variety of reasons like corporate announcements, macroeconomic announcements, financial result updates, Election results, Monitory policy outcomes, etc. These markets may expect a jerk in the prices of the underlying asset which may result in high volatility in prices i.e. a higher IV.

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Putting implied volatility into use:

Implied volatility is one of the most important numbers in Options trading. Lots of people are trapped as they don’t understand the IV and end up buying the Option at a much higher price than the real ones.

Expected move: Investors looking to hedge risk for their cash portfolio might want to buy options when IV is low to avoid paying huge premiums and benefit when volatility in the market kicks in to make their options contracts worth more than what they were at cost.

Differentiating expensive and cheap: Option writers who want to gain by insuring investors against any market fluctuations would want to write these contracts when there is high IV to collect more premiums for the risk he/she is taking and hold it long enough for the time decay to work its magic.

Adjusting notional values for Implied volatility: Options traders should never buy puts or calls when IV is too high since more or less IV will drop fast enough to make your options worthless in no time. It might do good to prefer trading cash or spot market since margin requirements are the same and there is no time decay or enough volatility to trade more quantities.

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Using implied volatility as a trading tool

  • IV shows the market’s opinion of the stock’s potential moves, but it doesn’t forecast direction. If the implied volatility is high, the market thinks the stock has potential for large price swings in either direction, just as low IV implies the stock will not move as much by option expiration.
  • To option traders, implied volatility is more important than historical volatility because of IV factors in all market expectations. If, for example, the company plans to announce earnings or expects a major court ruling, these events will affect the implied volatility of options that expire that same month. Implied volatility helps you gauge how much impact news may have on the underlying stock.
  • IV offers an objective way to test forecasts and identify entry and exit points. With an option’s IV, you can calculate an expected range – the high and low of the stock by expiration. Implied volatility tells you whether the market agrees with your outlook, which helps you measure a trade’s risk and potential reward.

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