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What is Implied Volatility (IV) and How does it affect options?

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In the world of options trading, there are several concepts you need to master to trade options contracts. Having a better understanding of such concepts may assist you when making trading decisions. Implied volatility (IV) is one of the metrics option traders often use. Mastering IV will help you understand the dynamics behind the pricing of options. Keep reading to learn what implied volatility is, how it affects options and how it works to measure the odds of a successful trade.

What Is Implied Volatility (IV)?

Implied volatility estimates the expected magnitude of a security’s future price changes. It signals an investor the probability of uneven changes in the price of the underlying security based on the supply and demand of a specific option contract. Simply put, implied volatility shows how volatile a security’s price may be in the future.

Implied volatility is one of the parameters used to determine the price of an option. Traders and investors can utilize IV to predict stocks’ future moves and apply that insight when pricing options contracts. Historical volatility is the second most popular metric that options traders tend to focus on. However, IV differs from historical volatility in that the latter gives an insight into future market movements based on past market changes.

How Does Implied Volatility Work?

What to Look For When Buying StockImplied volatility is the fluctuation in the market price of the underlying security. You can use it to estimate the future volatility of a security’s price based on several factors. IV is usually expressed on an annualized basis.

Implied volatility significantly increases during bearish markets when investors think that stock prices will drop over time. On the other hand, IV decreases during bullish markets when investors expect prices to surge over time. Bear markets are often risky to most investors.

It’s important to note that implied volatility does not forecast the direction in which the price change will go. For example, high implied volatility means a large price swing, but the price could swing high, low, or even both. Low implied volatility indicates that the price won’t make vast unpredictable swings.

How Does Implied Volatility Affect Options?

Options tradingImplied volatility is one of the major factors that influence options pricing. An understanding of how implied volatility affects options prices is vital when buying and selling options contracts. Being on the right side of implied volatility can significantly increase the success of an options trade.

Options are contracts that give you the right, but not the obligation, to buy or sell a security at a specific price and at a predetermined time. To purchase an options contract, you must pay an option premium. As implied volatility changes, option premiums change accordingly. Higher implied volatility means higher option premiums and vice versa.

Read more about options trading here.

Factors Affecting IV

Several factors influence implied volatility in options trading, with the most common being:

1. Supply and Demand

Supply and demand of the underlying security directly influence implied volatility. When there is a high demand for security, implied volatility will rise, and so does the security’s price. Securities with high implied volatility tend to have higher option premiums. Conversely, if the demand for security is low, implied volatility decreases, leading to a lower premium for the options contract.

The rise and fall of implied volatility due to the supply and demand of security determines the success of an options trade. For instance, if you own options when IV increases, option prices will rise. When IV decreases, you can incur significant losses.

2. Time Value

Another factor that affects implied volatility is the amount of time left in an option contract to expiration. If there’s not much time left for an option to expire, implied volatility would be lower. In contrast, a longer amount of time leads to higher implied volatility. Long-dated options tend to be too risky for option sellers because there is a lengthier time for the underlying assets price to move toward the strike price.

3. Market Condition

Market events such as earnings announcements, product approvals, possible mergers and acquisitions, and other news events may impact implied volatility. It is not uncommon to see implied volatility rise ahead of such events because there are many price movements. The demand for option sellers to participate in such events drives option prices higher. However, implied volatility may decrease after the market-anticipated events.

How to Use Implied Volatility to Your Advantage

Implied volatility can give you an edge by showing the probability that a stock will move up or down. This is great for quickly spotting changes in the market, but it also gives you an opportunity to make some profit. Here’s how you can use implied volatility to your advantage:

Understand IV and Standard Deviation

Implied volatility is the level of uncertainty in an option’s future price. When it comes to IV, standard deviation generally represents a 68.2% probability that a stock will reach a specific price range in one year.

Pay Attention to Expected News

When a company is about to announce major news, implied volatility changes accordingly. IV tends to increase during such periods and decrease once the actual events occur.

Pros and Cons of Implied Volatility

Like any other metric, implied volatility has its own set of advantages and disadvantages.

Pros

  • Quantifies the market uncertainty: Implied volatility can quantify market uncertainty by estimating the price movement an asset may make.
  • Determines option prices: High implied volatility means higher option premiums, so the option price is more expensive. The opposite is also true; low IV leads to lower premiums for the options contract.
  • Determines trading strategy: Implied volatility can help investors make informed trading decisions. During periods of high IV, investors can select safer investment options.

Cons

  • Sensitive to market conditions: Unexpected market events, such as earnings announcements and other news, impact implied volatility.
  • Predicts price movements but not the direction: Implied volatility only estimates future prices, rather than the direction in which price change will proceed.
  • It doesn’t quite fit reality: Since implied volatility is solely based on prices, not fundamentals, it doesn’t quite fit reality in that market prices are not naturally distributed.

Real-Life Example

Implied volatility is a measurement of how much the price of an option will fluctuate over time. In other words, implied volatility is the market’s prediction of the underlying stock’s future movement.

One way to gauge implied volatility is by looking at the CBOE Volatility Index (VIX). The VIX is an indicator of the market’s expectation of near-term volatility. It is a weighted average of options prices on S&P 500 Index stocks with at least 30 days to expiration.

Example of IV range
CBOE VIX range. Source: Yahoo Finance

The graph above shows an example of IV and its range. The peaks indicate when implied volatility is high, while the troughs imply low volatility. Looking at the VIX chart, you can predict the price of the underlying options. For example, if you had a VIX option, and the IV was rising, you can use that information to predict a future price drop.

Using IV along with other forecasting techniques can help investors get the most from their trades. While there’s no way to predict the future, understanding and using implied volatility and other concepts can help investors maximize returns and manage risk.

Further Reading:

Frequently Asked Questions

Why Is Implied Volatility Important?

Implied volatility is an important metric to understand when you’re looking at securities. It can help you assess how a security’s volatility and price range might look in the near future. That means it’s helpful as a prediction tool to see how markets are going to move over time.

How Do You Find Implied Volatility?

You can determine implied volatility using an option pricing model. The Black-Sholes Model is the most popular options pricing model, which factors in current stock price, strike price, interest rate, time to expiration, and volatility.

How Do Changes in IV Affect Option Prices?

Implied volatility is one of the most important factors in determining an option’s price. If there are changes in implied volatility, then the price of the options will change accordingly. As implied volatility increases, so do options prices and premiums, and vice versa.

The Bottom Line

Implied volatility is a valuable metric to use when pricing options contracts. With IV, you can buy an option that tracks the price of the underlying security more closely and has less risk than other types of options. This means it’s easier for investors and traders who are new to this financial instrument, as well as seasoned professionals, to manage their risks and make better decisions with their money.

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