Options offer significant advantages over other financial instruments, whether used to make a profit or hedge a portfolio. To trade options correctly, it is essential to understand the mechanisms that affect options prices.
Implied volatility is an integral part of options pricing. Your chances of success as an options trader can be significantly increased by considering implied volatility in your trading decisions. You can now find out what implied volatility actually is and how you can benefit from it strategically.
Implied volatility and historical volatility: An important difference
Implied volatility measures how likely the market or stock will move in the future. It is expressed as a percentage. This value can help you estimate the intensity of a stock’s price movement over a period of time. However, the implied volatility does not predict which direction the stock will move. So, by definition, implied volatility is simply the amount that the stock price could fluctuate over a period of time, regardless of price direction.
The Chicago Board Options Exchange (CBOE) Volatility Index VIX is the most famous measure of implied volatility. The VIX, also known as the “fear index,” measures the implied volatility of the American index S&P500. Its value is determined using the prices of S&P500 options.
Historical volatility, in turn, refers to past fluctuations in the market or stock in question. Historical volatility is not indicative of future fluctuations. A stock may have been very volatile historically but may only fluctuate slightly over the coming months.
For the forward-thinking options trader, implied volatility is more important than historical volatility because implied volatility relates to future price movements. For example, when a new drug approval date is approaching, that pharmaceutical company’s stock will have high implied volatility. This high implied volatility then impacts the price of options that expire after that date.
Implied volatility is a dynamic number constantly changing based on options market activity. It is heavily influenced by the supply and demand for options on the underlying asset.
Relationship between implied volatility and standard deviation
If you are interested in implied volatility, you will occasionally come across the term “standard deviation.” Without falling into the mathematical jargon for a long time, an explanation of this term should be provided at this point using an example.
In statistics, a standard deviation is a measurement that encompasses approximately 68% of all results. The value of the implied volatility in percent corresponds to an annual standard deviation.
In other words, if the implied volatility of a stock trading at $100 is 15%, that means there is a 68% chance that the stock will move between -15% and +15% over a year. We could also put it this way: there is only a 32% chance that the stock will be outside the range of $85 and $115 in one year. Statistics also tell us that the stock would stay between $70 and $130 95% of the time (two standard deviations) and between $55 and $145 99% of the time (three standard deviations).
But beware! Keep in mind that these numbers refer to a theoretical world. In fact, there are times when a stock will move outside the range defined by the third standard deviation, and they do so more often than you think. Unexpected bad news, for example, could send a stock so plummeting it would drop out of the three-standard deviation range. So implied volatility is not an infallible indicator of price action!
If you can estimate where the stock might statistically trade over a period of time, you’ll also be better able to decide which options to buy or short and what strategies to implement.
As mentioned earlier, implied volatility allows you to estimate the likelihood that a stock will trade at a given price at the end of a 12-month period. But you might rightly say, “That’s all right, but I never trade 12-month options. How can implied volatility help my short-term trades? ”
That’s an excellent objection. The most commonly traded options have 30 to 90 calendar days to expire. Here’s a rule of thumb that you can use to calculate implied volatility over the life of your option:
For example, if the annual implied volatility is 15% and you trade an option with a term of 45 days, then the implied volatility for the 45 days is approximately 6.3%. Accordingly, there is a 68% probability that the underlying stock will move between -6.3% and +6.3% in the next 45 days.
How implied volatility affects options
The implied volatility corresponds to the expected fluctuations (regardless of price direction) of a share over the option’s life. When expectations change, option prices react accordingly. When high volatility is expected and when there is a lot of uncertainty about a stock, the implied volatility of that stock increases. Options with high implied volatility are more expensive and offer higher rewards accordingly.
Conversely, implied volatility decreases when only lower fluctuations are expected and when the uncertainties fade away. Options with lower implied volatility result in cheaper option prices. This relationship is critical to understand because the rise and fall in implied volatility determine how expensive or cheap an option’s time value is, which in turn can affect the success of your options trade.
Measuring the sensitivity to implied volatility
An option’s sensitivity to changes in implied volatility is measured by a Greek value called “Vega”.
For example, if you have bought options, increasing implied volatility will help make your options more expensive. In that case, your position has a positive Vega. Of course, other factors also play a role in the pricing of the option, such as the share price itself and the option’s remaining life. However, options are susceptible to changes in implied volatility, so in some cases, the price movement of stock plays only a minor role in pricing the options.
At-the-money or near-the-money options, with strike prices very close to the current price of the underlying stock, are more sensitive to changes in implied volatility than options that are deep in the money or out-of-the-money. The Vega value of options that are close to the money is correspondingly high.
This property is easy to explain. At-the-money options are the ones that are traded the most. Because implied volatility is highly dependent on supply and demand, these options tend to be the ones with the higher implied volatility.
Options with short remaining maturities (say, around 50 days) will be less sensitive to changes in implied volatility, while long-dated options will be significantly more sensitive. For long-term option, the Vega value is higher.
However, special events such as takeovers, profit warnings, and bankruptcy rumors can shake these models. You should always pay attention to such events.
Comparing volatilities: Everything is relative!
If you read the implied volatility of a stock, this value does not say anything about whether the stock is currently very volatile or not. The value must always be set in relation.
For example, if you read that a stock’s implied volatility is 25%, you still need to know whether that figure is high or low. 25% might be very high for a stock like Procter & Gamble. For a stock like Tesla, 25% is a meager figure. Tesla is fundamentally much more volatile than Procter & Gamble.
While Procter & Gamble mainly fluctuates between 11% and 30%, Tesla’s implied volatility ranges between 40% and 85%.
Implied volatility assessment tools: volatility ranking and volatility percentile
The volatility ranking is a measurement from 0 to 100 that determines the low and high points of implied volatility over a given time period and compares the current implied volatility to these points.
A time frame of one year is usually considered. For example, if a stock’s implied volatility has a low of 20% and a high of 60%, a volatility ranking of 50 would mean that the implied volatility is currently 40%. If the same stock had an implied volatility of 20% or less, its volatility ranking would be 0. If it had an implied volatility of 60% or more, it would have a volatility ranking of 100.
One of the problems with the volatility ranking is that it doesn’t account for outliers. If a profit warning jumped the implied volatility to 200% for just one day, the volatility ranking for the stock mentioned above would be 100, just as if the implied volatility were only 60%.
The volatility percentile tries to overcome this weakness and offers an alternative measurement method.
The volatility percentile counts all the days for which the stock’s implied volatility was below today’s implied volatility and divides this value by the number of trading days (typically 252 days for a year). If the volatility percentile is 93%, it means that 93% of all trading days in the period under consideration had implied volatility lower than actual volatility.
Strategic use of implied volatility: buy the calm, sell the uncertainty
Imagine for a minute that you live on the beaches of the Baltic Sea. If you see the water level at the beach every day, you can quickly tell when the water level is high or low. A tourist could not assess this very well and might think that extraordinarily high or low water levels are normal. It is similar to implied volatility. Using the volatility ranking and volatility percentile, you can now get a good idea of the highs and lows in implied volatility over time.
This allows you to determine when the underlying options are relatively cheap or expensive. By seeing where the relative highs are, you can anticipate a future fall in implied volatility or at least a return to the mean. On the other hand, if you notice that the implied volatility is low, you can anticipate a possible increase in the implied volatility.
Implied volatility moves in cycles. Periods of high volatility are followed by periods of low volatility and vice versa. This concept is essential when determining an appropriate strategy to maximize returns and minimize risk.
How to profit from implied volatility
When you find options that pay expensive premiums due to high implied volatility, you need to realize that there must be a reason for that. Check the news to determine why high underlying stock swings are expected.
Typically, you’ll see implied volatility spike a few weeks before quarterly earnings are released. This is a normal phenomenon: there is uncertainty about these reports ahead of the quarterly results. Will they be better or worse than expected? As long as this question is not answered, the implied volatility usually stays high. As soon as the quarterly results are released, the implied volatility collapses as the uncertainty is suddenly gone.
Always remember that as implied volatility increases, option premiums increase. As implied volatility decreases, options become cheaper.
Buying options may be considered if a stock’s implied volatility is near its lows. This can be done, for example, by buying long-term calls and puts, long straddles, and debit spreads.
When you find options with high implied volatility, that is, when anticipating a volatile stock move, consider selling strategies. When implied volatility is close to a high, option premiums are correspondingly high: shorting options could be a winning approach. Strategies such as covered calls, naked puts, short straddles, short strangle, and credit spreads can be used for this purpose.
Looking at implied volatility is necessary to make better decisions when choosing suitable options and the right strategies. This knowledge will help you identify the right time to buy or sell options.
However, it must be considered that implied volatility is only what the market expects of a stock theoretically. However, the real world only sometimes matches the theoretical world. In the 1987 stock market crash, the market moved 20 standard deviations. Statistically, the chances of such a move were close to zero. But in reality, it happened anyway.
While implied volatility is not always 100% accurate, it should be an indispensable tool in your options trading.