In the world of options trading, understanding implied volatility (IV) is crucial. But what exactly is IV and why does it matter? Let’s explore.
What is Implied Volatility?
In simple terms, implied volatility measures how much the market expects a stock’s price to change in the future. It is implied by the prices of options contracts, which give investors the right to buy or sell a stock at a certain price within a specific period.
In other words, IV reflects the “implied” level of risk and uncertainty in the market. When IV is high, options traders expect significant price movements for the underlying stock. On the other hand, a low IV indicates that the market anticipates relatively stable stock prices.
In options trading, IV is often compared to historical volatility (HV), which reflects the actual price fluctuations of a stock in the past. This comparison can provide insight into whether options are overpriced or underpriced. If IV is higher than HV, it suggests that investors have high expectations for the stock’s future performance.
How to Calculate Implied Volatility?
Calculating implied volatility isn’t a straightforward process, as it’s not a known variable, but is derived from an option’s price. It’s often calculated using iterative numerical methods. The Black-Scholes model is one of the most commonly used methods to indirectly compute IV.
In reality, IV is found by using the actual market price for the call option and solving the equation for IV. This usually involves a numerical method like the Newton-Raphson algorithm or a simpler method like the bisection method. It’s worth noting that these calculations are typically performed by trading software and platforms.
The Importance of Understanding Implied Volatility
As mentioned, IV is a crucial factor in options trading. It can greatly affect the value of an option contract and therefore impact potential profits or losses for traders. Let’s take a look at some key benefits and risks of not understanding IV.
- Helps identify potentially profitable options contracts: If a trader believes that IV is overstated, they may consider selling options contracts at a higher price and potentially make a profit if the IV decreases.
- Provides insight into market sentiment: A high IV can indicate an upcoming market event or uncertainty, while a low IV can suggest stability and confidence in the market.
What is Historical Implied Volatility?
In simple terms, historical IV is the actual volatility of an asset’s price over a certain period. It’s calculated by comparing the current market price of an option to its past performance.
For example, let’s say Company ABC stock has had a historical IV of 20%. If the current market price implies an IV of 30%, this means that traders are expecting more volatility in the future compared to the past.
An option trader can chart the historical IV and current IV to gauge the potential profitability of a certain options trade.
What is a Good Implied Volatility for Options Trading?
Implied volatility plays a significant role in options pricing, profoundly influencing the decision to buy or sell options.
High implied volatility often leads to an increase in options prices. This is because the increased risk and uncertainty represented by a high IV increases the chance of the option being profitable, thus driving up its market price.
Traders may find this situation advantageous when they are selling options, as they can command higher premiums.
On the other hand, low implied volatility suggests more stable prices for the underlying stock, reducing the probability of the option moving in the money.
This stability typically results in lower options prices. For option buyers, a low IV environment can be more favorable, allowing them to purchase options at cheaper rates.
However, it’s important to remember that volatility is just one factor among many that influence options prices. Other factors include the price of the underlying asset, the strike price, the time to expiration, and the risk-free interest rate. Therefore, traders should consider all these factors collectively when deciding to buy or sell options.
It’s also important to select the right options strategy to trade rather than solely focusing on implied volatility based on their risk tolerance and investment goals.
What are implied volatility rank and implied volatility percentile?
Implied Volatility Rank, or IV Rank, is a metric used by traders to gauge whether implied volatility is high or low on a relative basis. It measures the current implied volatility against the range it has marked over a particular period, typically the past year. The calculation is a simple percentage of the number of days with lower implied volatility in the past year (or chosen time period), with the current level being the highest, or rank of 100%, and the lowest level being the rank of 0%.
For example, if an option’s implied volatility has ranged from 20% to 50% over the last year and is currently at 35%, the IV Rank would be 50%. This means the current implied volatility is higher than 50% of the readings over the last year. Traders use the IV Rank to determine whether an option is cheap or expensive based on its historical volatility and to make informed decisions about trade strategies.
Remember, a high IV Rank signifies that the current implied volatility is at the higher end of its 12-month range, which might suggest that options are overpriced and it could be a good time to be an options seller. Conversely, a low IV Rank might indicate that options are relatively cheap, potentially favoring an options-buying strategy.
Implied Volatility Percentile, or IV Percentile, is another critical metric for traders. It measures the percentage of days in the past year (or your chosen time period) when the implied volatility was lower than the current level. Unlike the IV Rank, the IV Percentile accounts for the frequency of each IV level rather than just the highest and lowest points.
For instance, let’s assume that over the past year, an option’s implied volatility was lower than its current level of 30% on 180 days. This would equate to an IV Percentile of 50% (180/365), indicating that the current implied volatility is higher than 50% of its readings in the last year.
Though the two terms sound similar, the key difference between IV Rank and IV Percentile is that IV Rank considers the highest and lowest IV levels, while IV Percentile takes into account how many days the IV was below the current level. Understanding these subtle differences can help traders make more informed decisions about when to buy or sell options based on the relative cost of options.
What kind of events could cause Implied Volatility to increase?
Potential factors that can cause IV to increase:
- Earnings announcements: Companies releasing their quarterly earnings reports can greatly affect the price and volatility of their stock.
- Market news or events: Major political or economic events such as elections or trade deals can have a significant impact on the sentiment of specific market sectors or companies.
- Clinical trial results: The announcement of clinical trial results, particularly for pharmaceutical and biotechnology companies, can significantly influence the stock’s price.
- Product launches: In the tech sector, for instance, the launch of a new product or service can cause a spike in implied volatility.
- Regulatory decisions: Companies in highly regulated industries like healthcare, finance, or energy can experience changes in implied volatility due to upcoming regulatory decisions or policy changes.
- Mergers and acquisitions: The announcement of a merger or acquisition can lead to price volatility as investors assess the potential implications of the deal.
- Major company news: Any significant news related to a company, such as changes in leadership, major lawsuits, or accounting scandals, can cause a shift in implied volatility.
High Implied Volatility Option Strategies
High implied volatility often presents a unique opportunity for traders to capitalize on certain strategies, offering the potential for high returns.
Below are four key options trading strategies ideal for situations when implied volatility is high.
- Short Straddle
- Short Strangle
- Iron Condor
- Butterfly Spread
The Short Straddle strategy involves selling both a call and a put option with the same strike price and expiration date. This strategy is profitable when the underlying asset’s price remains relatively stable, and implied volatility decreases.
When initiating a short straddle position during high implied volatility, we are taking advantage of the inflated prices of options contracts due to uncertainty in the market. As time passes and implied volatility decreases, these contracts become less valuable, allowing us to buy them back at a lower price and pocket the difference as profit.
From an options Greek perspective, short straddle positions have a negative vega, meaning they benefit from a decrease in implied volatility. However, it is essential to keep in mind that this strategy also has unlimited risk if the underlying asset’s price moves significantly.
Similar to the short straddle, a Short Strangle involves selling a call-and-pull option with different strike prices but the same expiration date. This strategy is also profitable when the underlying asset’s price remains stable and implied volatility decreases.
Since this strategy involves selling out-of-the-money options contracts, it has a lower risk compared to the short straddle. However, it also has a lower profit potential due to the lower premiums received from selling the options.
From an options Greek perspective, short strangles have a negative vega and positive theta, meaning they benefit from both a decrease in implied volatility and time passing.
The Iron Condor strategy is a combination of both a Short Strangle and a Long Strangle. It involves selling an out-of-the-money call and put option while simultaneously buying a further out-of-the-money call and put option with the same expiration date.
As implied volatility decreases, the premiums for these options contracts also decrease, allowing us to buy them back at a lower price and lock in a profit. The risk is limited in this strategy as we have both a short and long position, providing some hedging against potential market moves.
From an options Greek perspective, Iron Condors have negative vega and positive theta, similar to the Short Strangle. However, they also have a positive gamma, meaning they benefit from small price movements in the underlying asset.
The Butterfly Spread strategy involves buying an out-of-the-money call-and-put option while simultaneously selling two at-the-money options with the same expiration date. This creates a profit range where the underlying asset’s price needs to stay within for maximum profit.
When implied volatility decreases, the premiums for these options contracts also decrease, allowing us to buy them back at a lower price and lock in a profit. From an options Greek perspective, Butterfly Spreads have positive theta and negative vega, meaning they benefit from both time passing and a decrease in implied volatility.
Low Implied Volatility Option Strategies
Low implied volatility often presents a unique opportunity for traders to capitalize on certain strategies, offering the potential for high returns.
Below are six key options trading strategies ideal for situations when implied volatility is low.
- Long Calls or Puts
- Long Straddle or Strangle
- Calendar Spread
- Ratio Spread
- Diagonal Spread
- Butterfly Spread
LONG CALLS OR PUTS
Long Calls and Puts are basic options trading strategies that can be profitable when implied volatility increases.
With a Long Call, the investor purchases the right to buy an underlying stock at a predetermined price within a specified time frame.
On the other hand, a Long Put gives the investor the right to sell an underlying stock at a predetermined price within a specific timeframe.
Disregarding the directional profit and timeframe, increased implied volatility will cause options pricing to rise, thus increasing the value of the option contract.
LONG STRADDLE or STRANGLE
Long Straddle and Strangle are advanced options trading strategies that can be profitable when implied volatility increases.
Both strategies involve buying a Call and Put position at the same strike price and expiration date.
The difference between a Long Straddle and a Long Strangle is that in a strangle, the strike price for the Put and Call options are different.
The benefit of these strategies is that they profit from a significant change in the underlying stock’s price, regardless of which direction it moves.
When implied volatility increases, options pricing will rise, increasing the value of both Call and Put positions.
A Calendar Spread strategy involves purchasing a longer-term call or put option while simultaneously selling a shorter-term one with the same strike price.
This strategy profits from the difference in time decay between the short and long positions.
When implied volatility increases, longer-term options will experience a more significant increase in pricing compared to shorter-term options.
This results in an increase in the value of the longer-term option position, producing a profit for the trader.
The Ratio Spread strategy involves purchasing a different number of Call or Put options at different strike prices.
For example, a trader may buy two Call options with a lower strike price and sell one Call option with a higher strike price.
This strategy takes advantage of changes in implied volatility, as an increase will lead to a more significant rise in the value of the purchased options, generating a profit for the trader.
A Diagonal Spread strategy involves buying and selling Call or Put options at different strike prices and expiration dates.
This combination allows for flexibility in both time and price movement, which can be advantageous when implied volatility is low.
If implied volatility increases, longer-term options will experience a more significant increase in pricing compared to shorter-term options, generating a profit for the trader.
The Butterfly Spread strategy involves selling two Call or Put options at a specific strike price and buying one option on either side of that strike price.
This strategy is profitable when the underlying stock remains relatively stable, but implied volatility increases.
As the sold options will experience a more significant increase in pricing compared to the bought options, resulting in a profit for the trader.