Implied Volatility (IV) is an important concept in the options market. A simple explanation of IV is that it refers to the expected volatility or speed of change of an asset during the life of an options trade.
In this article, we will look at the concept of implied volatility in depth and how to use it in the market (sadly, not for short term trades).
Table of Contents
What is options trading?
To understand what implied volatility is, we need to first explain what options are. An option is a financial derivative that allows a trader to anticipate future price movements. In this regard, the options contract gives you a right but not an obligation to buy or sell an asset at a certain price.
There are two possible trades in this regard: call and put.
A call option gives you the option to buy the asset at a fixed price known as the strike or exercise price. On the other hand, the put option gives you the option to short the underlying asset.
If the price of an asset is below or above the strike price at expiry, it means that the options trade is worthless. At the same time, if the price rises above the strike price and a call option is placed, it means that the trader can decide to buy or avoid it.
The profit of an options trade comes from the difference between the asset value and the exercise price. The net profit is the difference between the gross profit and the price paid for the call.
What is implied volatility?
Implied volatility is defined as the expected variance or gyration of an asset’s price over its lifetime. In other words, it refers to the forecasted magnitude or standard deviation range of an asset during the period.
This is an important metric in the options market in that it highlights how volatile the asset will be during the options trade.
Low implied volatility means that the market expects the price to remain in a consolidation phase during the period. High implied volatility, on the other hand, means that the market expects huge swings.
In most periods, implied volatility rises in bull markets and falls during bearish markets. However, it is worth noting that IV does not predict the direction of an asset price. While a higher figure means that a large swing is expected but it does not tell the direction of that movement.
Related » Guide to Identify the Direction (and Strength) of a Trend
How implied volatility is calculated
Calculating the implied volatility of a stock is a relatively difficult process. Fortunately, you don’t need to do it since most options trading platforms provide the number to their trades.
One way of calculating this figure is known as the Black-Scholes model. It includes data points like the price of the option, price of the underlying asset, strike price of an asset, time until the option expires, and the risk-free rate of the return. The formula of calculating implied volatility is:
C = SN (d1) – N (d2) Ke -rt
In this case, C is the option premium, S is the price of the asset, K is the strike price, r is the risk-free rate, t is the time to maturity, and e is the exponential return. Here is an example.
Assume that a stock is trading at $450 and its call option is available at $45 with a strike price of $410. Also, assume that the risk-free rate stands at 2% and there are three months to cover (90 days). In this case, the calculation is:
45 = 450 X N (D1) – N(d2) X 410 X e-2.00% *(2*30/365)
In this case, we can assume that the implied volatility will be between 18% and 19%.
Implied volatility vs historical volatility
The opposite of implied volatility in the market is known as historical (HV) or realized volatility. HV, as the name suggests, refers to what happened in the past. In other words, it looks at an asset’s volatility in the past. It is calculated using the following formula.
rt= log(Pt)- log (Pt-1)
In this case, P is the stock price while t is the time.
Why implied volatility is important to traders?
Implied volatility is one of the most important numbers that day traders look at in the market. It is a crucial number even though it does not predict the direction of a financial asset. There are four main reasons why the number is important.
Predict the volatility of the trade
The most important reason why using implied volatility makes sense is that it helps to determine the volatility of an asset. This knowledge will guide you in determining the size of the options trade to implement.
It also helps traders determine whether a certain option is cheap or expensive. Implied volatility can also help you to identify undervalued options.
Research an asset
This number can also help you do research of an asset. In this, after identifying the figure, you can do research on why the asset is volatile.
Some of the reasons are the company’s earnings, macro themes, and company-specific news.
For short-term options strategies
Implied volatility is a good number to consider when identifying volatile assets to day trade. In most periods, options day traders look at high-volatile stocks.
As such, in this case, some of the most popular strategies you can use in these markets are credit spreads, naked puts, and covered calls.
For long-term options strategies
Similarly, IV can help you find options for long-term options trading strategies. Some of the most popular strategies to use in this case are debit spreads, naked long put/calls, and diagonal options.
How to read implied volatility
The implied volatility figure is usually provided by most options trading companies. The best way to look at this figure is to consider its historical number. In this case, if the IV is 10, it makes no sense if you don’t know where it normally averages.
Therefore, if the implied volatility of an asset is rising, it means that the market expects the asset to be volatile in the near term. On the other hand, if the figure is falling, it is a sign that the market expects the asset to be less volatile.
As such, you can use this data to determine the expiry price you want to use for your put and call options in the market. An asset with a high IV will often be highly volatile and vice versa.
What can affect implied volatility?
Implied volatility of an asset can be affected by numerous factors. The most popular factors in the stock market are:
- Earnings
- macro news
- company-specific news
- industry events.
For example, IV can increase ahead or after a company publishes its earnings report. Also, it can increase or fall when there is macro news like interest rates, inflation data, or credit rating downgrade.
Company-specific news include a new product launch, management change, and an activist investor. Industry-specific news are those that impact key industries like technology, manufacturing, and retail.
Is It possible to Use Implied volatility in day trading?
The concept of IV is mostly used in the options market. This figure is used in regular swing trading and investing. Since IV looks at longer timeframes, it is not useful in day trading.
A swing trader or investor can look at the implied volatility and historical volatility to determine the asset’s market swings. In this case, they can avoid stocks with low IV since they tend to have minimal market moves.
On the other hand, they can trade stocks with a high volatility because of the expected moves in the market.
Summary
The concept of implied volatility is important, especially among options traders. In this article, we have looked at what the number means and how to use it in the market.
Also, we have explained some of the best approaches to use it. One of the most important things to know about IV is that it does not tell you the direction of the asset.
External useful resources
- Think Like a Market Maker — Understanding Implied Volatility – Medium
