Implied volatility (IV) is one of the most important yet least understood aspects of options trading as it represents one of the most essential ingredients to the option pricing model. Implied volatility indicates the chances of fluctuation in a security’s price. It also helps investors calculate the probability of the price of a stock reaching a given mark during a specific time frame.
The difference between implied and historical volatility is that historical volatility, or realized volatility, is the analyzed standard deviation of stock price movements, while IV is based on the option’s price and expected future volatility.
Representation of Implied Volatility
Implied volatility is usually represented as a percentage indicating the expected standard deviation range. Standard deviation (SD) is a concept of statistical probability, and SD is measured as 1 SD, 2 SD, and so on. One standard deviation means that there is about a 68% chance that the price of option contracts will fall within the expected range, 34% on each side. This range goes in both direction of the scale, so there will be a probability of an increase or decrease in price.
To understand SD ranges for IV, let’s consider the following example. A $300 option has an annualized SD range of 20%. In terms of price fluctuation, the SD range for this stock will be $60.00. In terms of probability, we can say that there is a 68% probability that the price will increase to $360 or decrease to $240. It’s important to mention here that these are theoretical concepts and actual values can move beyond the first, second, and even third standard deviation.
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Calculation of Implied Volatility
Different methods are used to determine implied volatility. One such approach is the options pricing theory. This calculation method takes into account variables like interest rate, stock price, expiration, strike price, and volatility to arrive at a value. At-the-money options (ATM) are the go-to options for calculating implied volatility, as they have the most trading volume in the options market. Keep in mind, if the options are liquid, then supply and demand takes precedence over ATM. Investors also use price charts like the CBOE volatility index (VIX) to estimate expected volatility. The index is based on weighted prices of S&P 500 Index calls and puts spread over a variety of strike prices.
The prediction model for option implied volatility gives us a probability of movement, but it does not tell us in which direction this movement will take place. Therefore, all investors must consider the chances of an equal downside to the upside. The option contracts premium depends on the volatility. If the volatility is high, then there is a greater chance of gaining from the investment, so the premium is also high. The opposite is true for low volatility, so here the premium will be lower.
Another factor that impacts the volatility rating of an option is the time left to the expiration of that option. If there isn’t enough time left before expiry, then the implied volatility will be low. In contrast, more time means a higher probability of a fluctuation in the option’s price.
Video Explaining How To Profit When Volatility Increases
How to Take Advantage of Implied Volatility
When considering volatility levels, one of the best things to look at is a volatility chart. Most options trading platforms provide a means to examine current implied volatility levels. One thing that traders hone in on is the fact that implied volatility is far more predictable than stock market movement. When implied volatility rises, so do option pricing, but the volatility will eventually drop back to normal levels along with normal market expectations.
Looking at the figure below, we see that implied volatility keeps shooting up, then eventually makes its way back down. Option traders know this, so they sell options when volatility is high, and options are expensive and then repurchase them when volatility is low, and options are cheap.
Although, in theory, this is good practice, it’s a lot more challenging to execute in one might think. For this reason, volatility traders like to rely on a tool called implied volatility rank or IV rank. This helps traders properly evaluate current levels of implied volatility and forecast where it is likely going, allowing them to sell expensive options and then buy them back cheaper at a later date. This is because implied volatility moves in cycles. Low volatility periods are followed by high volatility periods, and the cycle continues.
Why is Implied Volatility Important?
Think of options as insurance, and when there is a high risk of insuring an asset, the coverage becomes expensive. For example, to ensure a driver that had several accidents, an insurance company would require a higher premium because the driver represents more risk. The same goes for the stock market. When the stock market becomes unpredictable due to an earnings announcement, world events, or any other factor, options become more expensive due to the higher risk and uncertainty about the future.
When trading options becomes uncertain and implied volatility increases, this is referred to as IV expansion. Here option prices will increase. When the outlook of the market becomes relatively stable, this is referred to as IV contraction. Here, implied volatility, as well as option prices decrease.
Like other valuation metrics, implied volatility has it’s pros and cons as well. IV helps investors test their estimates for price movement by comparing it with what the market has to say. It gives traders a means to measure option pricing from one stock to another without having to analyze each one individually so they have a better understanding if they should buy or sell. It also gives investors a basis to create their entry and exit strategy. However, implied volatility is not based on fundamentals, and it can also be affected by unexpected news and events.
Depending on where implied volatility is currently trading, different options strategies should be applied. Click here to get a full list of the top option strategies, and when each one should be applied to limit risk and maximize profit.