Implied volatility is a term which is very commonly thrown about in the context of options trading. I can tell you that it is a very important metric to consider when making your trading decisions. In fact, you cannot even talk about trading options without knowing the implied volatility.
But first things first: what really is implied volatility? It’s a very simple concept to understand but one that can take quite a lot of experience and acquired knowledge to interpret the right way when crafting your trading strategy.
In short, implied volatility is:
- the market’s assessment of the likely movement of a particular security.
- an important metric that is used to price options contracts.
In this article, we’ll get to understand implied volatility in much greater detail and understand how to use implied volatility when trading options.
What Is Implied Volatility? Understanding Options and the Motivation for Implied Volatility
To understand implied volatility (IV), it is important to understand options first. Options are relatively simple: Options are simply contracts that give the bearer the right to buy or sell an underlying asset such as a stock. This is done at an agreed price before the expiration of the contract. The price at which the underlying assets are traded is known as the strike price.
Buying options let you invest in a stock by purchasing it at a lower-than-market price. Options also provide an alternative route to shorting a stock if you’re bearish on the market: by purchasing a put option, you’re buying the right to sell the underlying option, but you aren’t required to sell it.
The price of the option itself, called the premium, depends on several different factors. One of these factors is implied volatility.
How Is Implied Volatility Related to Options?
It is the way the market perceives a future movement in the price of the security. This is an important metric investors frequently use to estimate the fluctuations in the future price of the security. Therefore, it can be used to predict the demand and supply dynamics. It is thus used to impart a price to an option.
Supply, demand, and the time value of an option have a major role to play in determining its pricing too. In fact, the demand and supply factors will have their bearing on it as well.
Apart from these factors, the price of the option will also depend on the strike price and the dividends on the underlying security.
Implied Volatility and The Option Premium
You will have realized that options are like insurance contracts in several ways. This is because they can help secure investments. Now, assume that the traders perceive large uncertainty in a security. They will now feel a greater demand for options. You could say that the implied volatility has increased in this case. Thus, the options will be higher priced. This is considering the way the traders perceive market uncertainty.
The opposite case is termed IV contraction. This happens when the future movements of a security are perceived to be without much uncertainty. This causes a decline in the demand for options and their prices will decrease.
3 Things Implied Volatility Tells You
It gives a lot of valuable insights as we shall see shortly. However, here are the main indicators that can be derived using this metric.
- Implied volatility helps you estimate the future fluctuations in the market.
- It can help you estimate the probability of events as well. You can figure out the probability of a particular stock reaching certain levels within a time frame using implied volatility.
- It helps determine the pricing of an option considering the market perception.
The volatility chart represents implied volatility as a function of time. The volatility chart is a great way to analyze information visually. This can make all the difference when you’re trading.
There are lots of software available which can help you estimate and chart implied volatility. You should give serious thought into analyzing these charts before you make any trading decision.
I highly recommend that you visit the Raging Bull web page that explains technical analysis tools. This is a great way to master some fundamental techniques every trader must use when formulating his trading strategies. This page is a great online resource that has been created by leading experts themselves.
Another great advantage of using a volatility chart is that you will be able to compare implied volatility levels over time. This will enable you to see when they spike or fall in relative terms.
Trading platforms generally calculate implied volatility using the Black Scholes formula. There’s no need to estimate the metric yourself or configure any parameters. You just need to choose a trading platform that can calculate it for you when you need it. The calculator system will automatically put in all parameters for you.
10 Ways Implied Volatility Helps You Make The Right Trading Strategies
What if there was a way to predict future price movements and also work out possible entry and exit points? Well, implied volatility can help you with just that. Let’s see some critical information that lies concealed in this powerful metric.
- Bearish vs Bullish: Implied volatility typically rises when the market is bearish. It decreases when bullish conditions are observed.
- Non-directional: It is important to note that it will only tell you about a likely price change. However, it has nothing to say about the direction of this change. You will not be able to know if the price will go upwards or downwards using implied volatility alone.
- Historical data: It can be perceived as “high” or “low”. However, this can only be done after you have analyzed the historical data for the underlying assets.
- When to buy or sell: You should consider buying an option if the implied volatility is small. On the other hand, if it’s high, it might be a good time to sell options.
- Future predictions: You can get a good idea of the future price of an option by calculating the implied volatility.
- Testing hypothesis: You can also test your predictions using implied volatility. You will now if the market conditions are in agreement with your perception. This way, you can forecast risks and profits as well.
- Tracing irregularities: There might be a possibility of irregular fluctuations in the price of the underlying asset. Implied volatility can help you trace that as well.
- Highs and lows: Using the IV, you will be able to estimate the possible highs and lows in the stock price by the time the option expires.
- Pricing levels: Implied volatility can be used to determine if options are underrated or overpriced. However, you will need the technical expertise to analyze implied volatility. Furthermore, it is imperative to interpret it correctly.
- Buying calls/puts: Whenever you buy a call or put option, you should make it a point to first analyze implied volatility. This will help you ascertain whether the option is priced right.
As you can see, the metric reveals a wealth of information.
The Bottom Line
Implied volatility is a measure of the way the market perceives the future price movements of a stock. This is from the time the option is created until when it eventually expires. Simply put, you can used implied volatility to predict how the future prices will vary and it can also be used to estimate options pricing.
Implied volatility is affected by market supply and demand dynamics. IV can rise or fall, signaling an increase or decrease in the price of the option respectively. In fact, implied volatility will also have a bearing on the way time value affects an option. Ultimately, it’s no secret that it will be a major force in making an options trade successful.
Traders usually analyze the volatility as a function of time. This will help to see if they are priced just right, are cheaper or overpriced. Volatility charts can be of immense help when trying to see volatility variations with time.
In this article, we saw some of the main things every trader must remember when using implied volatility in making trading decisions. Finally, remember to consider this great resource that will help you understand technical analysis tools. These form the backbone of any successful trading strategy.