What does implied volatility in out of money options forecast?

Market

Derivative analysis has many tools to decode the market’s true forecasts but implied volatility has been one of the most important one. We are all familiar with India VIX as a barometer of volatility but is that all volatility analysis has to offer?

Any volatility index will be weighted maximum for ‘at the money’ options and by tracking these indices all we are tracking is the centre point of the volatility moving up or down.

But what about the volatility for far options which is trying to infuse some reality into the market? Let’s understand what implied volatility of ‘out of money’ options has to offer to gauge the market.

Almost 98 percent in the money put options on the Nifty are quoting an implied volatility (IV) of 13.26 percent, whereas 102 percent in the money call options on the Nifty are quoting  an IV of 10.62 percent.

Now, why would there be a difference in the IV for equidistant options? The answer is:

1. A put option seller is seeking higher compensation (premium) than an option seller of a call option

2. Supply of put option is limited and buyers are more, whereas the supply of call options are ample and buyers are less

This scenario would occur if the market was expecting a higher probability of a correction than the probability of a rise.

These analysis are expiry specific and should be looked at in isolation.

In general, call options IV’s for up to a few strikes higher is lower due to negative correlation with the market. If the market goes up, IV falls. For this reason, the curve remains flat at times, but beyond a point it starts surging again. This inflection point can be taken as stiff resistance.

The inference of market placements would come by tracking the IV levels and comparing the change in them.

If the put side is steep, it means that IVs are higher for out of the money options and the market expects a negative movement for that expiry. Due to the modifier stated above for call options, what needs to be tracked is the flattened area beyond which the market doesn’t expect the instrument to move for the expiry.

A comparatively flattened or a less steep curve on the put side would mean that the market is normal and a bull run is expected. The flattened area for the call option will be slightly longer in this case from at the money, which means there is enough room for an upside.

If the volatility curve is flat on both sides, it means that the market doesn’t expect any sharp moves and it’s a good month for option writers in general to participate.

A volatile market, where a sharp move is expected on either side, could be indicated by an equally steep IV curve on both sides. This means that options writers are scared on both sides of the market and are looking for higher compensation.

This might be of help to traders looking to make money from option writing. But these expiries are the ones to avoid as the risk is high and the yields are low unless one knows how to manage the risk properly.

Disclaimer: The author is CEO & Head of Research at Quantsapp Private Limited. The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.