Implied volatility alerts an investor of the possibility of irregular changes in the price of the underlying security.
Implied volatility (IV) is one of the most important concepts a trader should understand before stepping into options trading. In the world of option trading, implied volatility signals the expected volatility in an options contract over its life span. Traders importantly use it to determine option pricing.
Implied volatility alerts an investor of the possibility of irregular changes in the price of the underlying security, as it is dependent on demand and supply of a particular option contract as well as expectation of the direction of share price. For option traders, implied volatility is more important than historical volatility because IV factors in all market expectations. For example, company’s earnings and some other news may affect trader’s interest. These events also affect the implied volatility of options which expires in the same month. Thus, it helps you gauge how much of impact the news may have on the underlying stock. Implied volatility simply shows the market’s opinion of the stock’s potential moves, but it doesn’t forecast direction. If the implied volatility is high, the market thinks the stock has potential for large price swings in either direction, just as low IV implies the stock will not move as much by option expiration.
Let’s see how an options trader can use IV to make more informed trading decisions.
1. Identify entry and exit points –If your outlook on a specific underlying is positive and at the same time implied volatility of the stock is also on the lower side, it’s a good opportunity to buy a call option as the premium will be comparatively cheaper. Hence, if a trader is looking to enter in option trade, he should look at the implied volatility as lower implied volatility results into cheaper option pricing. Thus, he can buy an option at lower price. Similarly, in case implied volatility is high one should prefer writing options according to your outlook on stock rather than buying expensive option.
2. Market expectation – As implied volatility factors in all market expectations one should track it to get better understanding of mass psychology. In a scenario, when implied volatility are high market expect huge movement. Thus, traders should remain cautions and adopt a proper hedged strategy to avoid adverse price movement.
3. Hints Reversal – Implied Volatility of every underlying has a range, in which it moves in normal market scenarios. For Example, implied volatility of Nifty is in the range of 10% -23% during normal market scenario (No events expected), if IV’s breaches the lower side or the higher side of the range one can expect chances of reversal in near term.
4. Boost profit potential - Tracking implied volatility is of great importance to option traders, as the success of their trade greatly depends on whether they are on the right side of the volatility as premium of options and IV’s have direct correlation with each other. Short-dated options have lower sensitivity to implied volatility whereas long-dated options have higher sensitivity to it as the time value priced into such option are on the higher side.
5. Helps in selection of strategies - Another important use of volatility analysis is in the selection of strategies. As we know that rise in volatility results into increase in option premium and vice-versa; as implied volatility levels changes, there will be an impact on the strategy performance. Thus, increase in IVs is positive for strategies like long call/puts, back spreads and long strangles/straddles. While, on the flip side, strategies like short options, ratio spreads and short strangles/ straddles works well when implied volatility is falling. Clearly, knowing where implied volatility levels are and where they are likely to go in near term can make all the difference in the outcome of strategy.
With this article we have tried highlighting what is implied volatility all about and how can one make use of same in his/her daily trading activity.
The author is equity derivative research analyst with Angel Broking.
Disclaimer: The above opinion is for reference only.