Last Updated on 7 September, 2021 by Samuelsson
Volatility in the market can be good or bad, depending on how you look at it. As traders, we need enough volatility to be able to make some money from the market, but the higher the volatility, the riskier the market. There are two ways to estimate market volatility, and one of them is implied volatility. What does this implied volatility mean in trading?
Implied volatility is a way of measuring market volatility by considering the market’s perception of the likelihood of changes in the price of a given security. It measures the expectations of the market participants about how the market would move in the nearest future. As with the historical volatility, both traders and investors use it to plan their activities in the market.
We will discuss the topic under the following subheadings:
- Implied volatility: what does it mean?
- How implied volatility works
- Implied Volatility and Options
- How to use implied volatility as a trading tool
- An example of implied volatility
- What are the factors that affect implied volatility?
- The merits and demerits of using implied volatility
Implied volatility: what does it mean?
Unlike historical volatility, also known as realized volatility or statistical volatility, which measures volatility by considering past market changes, implied volatility (IV) forecasts market volatility by considering what the market thinks about the future price movements, and it achieves this by estimating how investors activities affect options prices.
In other words, implied volatility uses the prices of certain stock and indices options to calculate what the market is saying about the future changes in the equity market. This metric is very useful to investors because it offers them a general range of prices that a security is anticipated to swing between and helps indicate when it is right to be in the market and when to exit.
Several factors can affect implied volatility, but the most significant ones are supply and demand and time value. It is important to mention that IV usually increases in anticipation of a bear market in the equity market and decreases when the market is bullish. And the reason is simple: high implied volatility results when options are trading at higher premiums, while low IV results when options prices are low.
As you would expect, the calculation of IV is intrinsically related to options pricing. In fact, while implied volatility is one of the key six factors used in options pricing models, it can’t be calculated unless the remaining five factors are already known. By and large, one of the benefits of IV is that it may be used as a sort of alternate measure for the actual value of the option because when the IV is higher, the option premium is higher as well. Generally, IV is expressed as a percentage with standard deviations over a given period.
How implied volatility works
As we stated earlier, implied volatility is a measure of the market’s expectation of the likely future price movement in a stock. Denoted by the symbol σ (sigma), IV is often considered a proxy of market risk, as investors use it to estimate future market fluctuations (volatility).
For an option, the implied volatility does not stay constant; it moves higher or lower for many different reasons. While these changes are gradual most of the time, there are a few situations when IV can fluctuate by a huge margin. Examples of such situations include:
- When the market declines rapidly: IV rises rapidly as investors scramble for options.
- When the market gaps higher, especially after it had been moving lower: With the fear of a bear market disappearing, options premiums experience a rapid decline.
- When high-impact news is released: When earnings are announced or any of the regulators makes far-reaching policy changes, option buyers become more aggressive than sellers, resulting increase in demand causes both implied volatility and option premium to increase.
Bringing this to the equity market, IV generally increases when the market is bearish and decreases when the market is bullish. Here is how it works: when investors believe equity prices will decline over time (imminent bear market), they aggressively buy options to protect their downside risks, thereby increasing the demand for options, which, in turn, pushes IV and options premiums higher. Conversely, when investors believe that equity prices will rise over time, they don’t buy options to protect their downside, so there is less demand for options compared to supply, which pushes both IV and premiums lower.
While IV does not directly predict the direction in which the price change will proceed, due to the way it is calculated, it is biased toward bearishness — it is more likely to increase in anticipation of a bearish market than it will in anticipation of a bull market. Of course, bearish markets are considered by most equity investors to be undesirable and riskier.
Implied Volatility and Options
Options contracts give the buyer the right (not an obligation) to buy or sell the underlying asset at a specific price (strike price) during a pre-determined period. To get that buying right, the option buyer has to pay the option seller an amount known as the option premium. This premium is significantly affected by implied volatility.
In fact, implied volatility is one of the six deciding factors used in options pricing models, and it is the only factor among the six that isn’t directly observable in the market. It can only be calculated when the remaining five factors are already known. IV approximates the future value of the option, such that when it is higher the option premium is higher.
What is a good implied volatility for options?
There is no specifically perfect implied volatility for options as it fluctuates throughout the life of the option. IV, as you know, represents the expected volatility of a stock over the life of the option. As this expectation changes, the option premium would react accordingly. Hence, IV is directly influenced by the supply and demand of the underlying option and the market’s expectation of the direction of the stock’s price.
When the expectation rises, the demand for an option increases. And what does implied volatility do? Of course, it will rise. So, an option with a high IV will have a high premium. On the other hand, when the market’s expectation decreases, the demand for the option diminishes, and IV will decrease. Thus, an option with a low IV would have a low premium.
This is important because the rise and fall of implied volatility will determine how expensive or cheap time value is to the option, which can, in turn, affect the success of an options trade. The rule is always to buy low and sell high.
What is considered low implied volatility?
To ascertain whether the implied volatility of a security is high or low, most analysts would often compare the implied volatility to the historical volatility. This allows them to know how the expected compares with what has been experienced in the security over time.
For example, an IV of 15 could be considered high if the average historical volatility in the stock is 10. On the other hand, an IV of 90 could be considered low if the average historical volatility in the stock is 110. So, there’s no absolute value of IV that can be called low without comparing it with the historical volatility in that security.
Implied volatility and options pricing models
Implied volatility can be determined by using an option pricing model, such as the Black-Scholes Model and the Binomial Model, and it is also one of the six factors used to calculate option premiums.
When calculating implied volatility, options trading volume is critical. The trading volume is typically highest for at-the-money (ATM) option contracts, which are generally used to calculate IV. An options pricing model can be used to determine IV if the price of the ATM options has been determined.
How do you calculate the implied volatility of a stock?
Calculating the implied volatility of a stock involves the use of very complex mathematical models, such as the Black-Scholes Model. Since IV is not directly observable, it needs to be solved using the other five factors of the Black-Scholes Model. Those five factors are as follows:
- The market price of the option
- The price of the underlying stock
- The option’s strike price
- The time to expiration
- Risk-free interest rate
To calculate the implied volatility, you enter the market price of the option into the Black-Scholes formula and back-solve for the value of the volatility. Alternatively, you can use an iterative search approach, or a trial and error method, to find the value of implied volatility.
How to use implied volatility as a trading tool
To use implied volatility as a part of your trading arsenal, you should understand that the importance of implied volatility is because it gives investors insight into the collective market expectation about the future price movement in a specific stock or the broad market. Implied volatility indicates whether the expected movements will be large, moderate, or small, but it doesn’t forecast the direction of the said movements.
Also, you should know that IV is different from historical volatility (HV). While HV uses past price movements to calculate the average volatility, which gives insight about future price movements, IV tries to estimate investors’ expectations about future price movements. So, traders find the IV more useful, but would often combine the two when making a trading decision.
For instance, you can use IV to calculate the expected price range for an option throughout its life. This will show the expected highs and lows for the option’s underlying stock and also indicate potentially good entry and exit points. However, you will have to compare your results with what has been obtainable in the stock using the HV. It is then that you can decide whether the risk and reward are worth the investment.
What factors can affect implied volatility?
As expected, IV is usually affected by most of the same factors that affect the general market, but we will focus on two primary factors, which are as follows:
- Supply and demand: Just as general market prices typically rise in response to high demand and typically fall when demand is low, implied volatility also increases with demand and falls when demand is low. High demand leads to a higher premium since the option has been deemed as having a greater chance to pay off. Conversely, a low demand causes prices and IV to decrease, as there is enough supply and the market isn’t seeking it as aggressively. When the price and IV drop, the option is considered not necessary, so the premium is lower.
- Time value: This is the other primary factor that affects implied volatility. Time value refers to the length of time left before the option reaches its expiration date. Options with short expiration periods tend to have low IV, while options with longer expiration periods tend to have high IV. Here is why: Since implied volatility indicates the swing of movement, but not the direction, the longer the time before expiration, the longer the stock needs to move either in or out of the trader’s favor. While this makes it riskier, it also offering greater potential to eventually become profitable.
The merits and demerits of using implied volatility
The merits of implied volatility include the following:
- It quantifies market sentiment and uncertainty: By estimating the size of the expected future movements in a security, IV quantifies market sentiment.
- It helps set options prices: Option writers use complex calculations to arrive at the right price for their options contracts, and IV is a key factor in those calculations.
- It determines trading strategy: Many investors consider the IV when choosing an investment. For example, during periods of high volatility, they may choose to invest in safer sectors or products.
Despite the merits, implied volatility has some demerits, including the following:
- It is based solely on prices and not fundamentals: IV does not consider the fundamentals of the underlying security; it focuses only on price.
- It is sensitive to unexpected factors, such as news events: Unfavorable news or events, such as wars or natural disasters, can impact the IV.
- It predicts movement, but not direction: Generally, implied volatility does not indicate the direction of the movement.