Implied volatility in options trading explained

Downward trend
Rebecca Cattlin
By :  ,  Financial Writer

Implied volatility is a key factor when it comes to pricing options – it helps traders understand the market’s expectation of changes to underlying prices over a given period. Let’s take a look at what implied volatility is and how you can use it in your trading strategies.

 

What is implied volatility?

Implied volatility is a measure of the market’s view on likely changes to a security’s price. You can think of it as a projection of likely price movements based on sentiment, rumours and expectations. The intrinsic value of the underlying asset doesn’t change at all, but the perception of its value is changing.

It’s in contrast to historical volatility, which is the annualised standard deviation of past stock movements – i.e. how much the share price fluctuates on a daily basis over a single year.

Implied volatility is typically used more as a representation of market risk. It’s believed to increase when there is a bearish attitude and stock prices are declining, as this is seen as a riskier environment. On the other hand, implied volatility may decrease when sentiment is bullish and share prices are rising.

Although this is what markets perceive as the pattern, it’s important to note that implied volatility does not predict the direction of a market. Volatility, by definition, is the speed and extent of a price fluctuations. So, implied volatility only tells us when markets expect price changes are going to get quicker and larger, not what direction the price will go in.

 

 

Implied volatility and options

Implied volatility is most often used when pricing options contracts. Buying an option would give you the right to buy or sell an asset at a specific price before a set expiry date, which you’d pay a premium for. This premium changes depending on the value of the option. 

As implied volatility estimates the future value of the option, the higher the implied volatility – as in the greater the chance the price will make a large move – the higher the price of options premiums.

Implied volatility lets traders know the likely range a share could move in, and when a good time to buy is. For example, if a stock has an implied volatility of 50%, you know the options market is expecting that share’s price to move 50% over the next year. This could increase the chances that an options contract will move beyond a strike price and into the money. 

 

Implied volatility and the Black-Scholes model

The most widely known means of calculating the price of options is the Black-Scholes model, which factors in the current underlying share price, the option’s strike price, time until expiration and risk-free interest rates. It puts together a number of variables, known as ‘The Greeks’, of which implied volatility is one.

The Greek that accounts for implied volatility is called Vega. It measures the annual expected range of the underlying market to estimate the impact that implied volatility might have on an option’s price.

For example, a stock option worth $100 with a Vega of $10 would tell us that each 1% change in the implied volatility of the option would increase its value by $10 – regardless of whether the share price moves at all.

 

How to calculate implied volatility

Calculating implied volatility is complex as it’s the only aspect of the Black-Scholes model that isn’t an actual figure to be found in the market. It requires us to reverse engineer the Black-Scholes pricing model, using all the other known data points.

Usually, this is done through mathematical programmes, or using Excel spreadsheets, as it requires a lot of trial and error.

Here are the steps:

  1. Collect all the inputs of the Black-Scholes model – this includes the market price of the underlying, the market price of the option, the strike price of the underlying, the time to expire, and the risk-free rate
  2. Input the above data into the Black-Scholes Model formula below
  3. Perform an iterative search – this is done through the use of trial and error

 

Implied volatility formula

 C = SN (d1) – N (d2) Ke -rt

Where,

  • C is the Option Premium
  • S is the price of the stock
  • K is the strike Price
  • r is the risk-free rate
  • t is the time to maturity
  • e is the exponential term

 

Understanding implied volatility

Understanding implied volatility is a little complex, as it relies on a basic grasp of statistics. As a starting point, we need to understand standard deviations, which is a measure of the amount of dispersion or variation in a set of values, relative to the mean.

According to the theory these statistics are based on, each stock should have one standard deviation from its original price approximately 68% of the time within a year. Implied volatility, then, is the market’s view on whether how big this standard deviation would be.

So, let’s say shares of ABC are trading at £40, and the implied volatility of its options contract is 20%. This means that the market believes that a single standard deviation over the next year would increase or decrease the share’s price by £8 – 20% of 40 is 8.

That means that there is a 68% probability that shares of ABC will end the year trading somewhere between £32 and £48.

It also means there’s a 16% chance the price will trade below £32, and a 16% chance it would trade above £48.

Knowing the probability that a share price will trade within a certain range can help us determine what option’s strike price is most likely to end up earning us a profit. 

 

How to trade implied volatility

Trading implied volatility is all about market sentiment. Like everything else, implied volatility has peaks and troughs. High-volatility periods are bound to be followed by low-volatility periods, and vice versa. So, using relative implied volatility ranges combined with other technical analysis indicators can help traders understand the best times and assets to trade.

Implied volatility strategies essentially involve finding cheap options and selling them when the price goes up. As implied volatility hits extreme highs or lows, it is likely to revert to its mean – so if you find an option that’s either cheap or expensive, it’s likely to move toward its average cost overtime.

These strategies would work as follows:

  1. When you see an option trading at low implied volatility levels, you might consider buying. As options premiums become cheaper, they become more attractive to buy and it’s less likely anyone would sell them
  2. When you see an option trading with high implied volatility levels, you’d switch to selling strategies. When option premiums become expensive, they’re less attractive to buy and it’s more likely people would sell them

 

What is a high implied volatility?

High implied volatility is a subjective term, as it depends on the average range for any given stock. For example, a high implied volatility for one share might be 10%, and for another it could be just 2%. It all depends on how much that share price is known to deviate from its norm.

 

Is the VIX implied volatility?

Yes, the VIX – short for the CBOE Volatility Index – measures the implied volatility of S&P 500 options over the next 30 days. When implied volatility is high, the VIX Is high because it’s likely the index’s price will span a broader range. When implied volatility is low, the VIX level would be lower and its trading range narrower.

Learn more about the VIX

How to trade implied volatility with FOREX.com

You can speculate on options prices and the Volatility Index with FOREX.com in just four easy steps:

  1. Open a FOREX.com account, or log in if you’re already a customer
  2. Search for the market you want to trade in our award-winning platform
  3. Choose your position and size, and your stop and limit levels
  4. Place the trade

Or you can try trading risk free by signing up for our  demo trading account.

 

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