Implied Volatility or IV as it is popularly known is mentioned a lot in discussions about Options trading. IV is one such integral part of Options that may not be as important a driving force as the price of the underlying stock/index but it is required to be understood and considered while trading Options.
Let us understand what IV is first and then its impact on Option prices along with our action with respect to IV.
Option Premium is calculated using 5 following factors:1. Stock/Index Underlying Price
5. Volatility in the Underlying
First 4 factors are known to each and every one of us and there is no disagreement in its value among any of us. However, the volatility figure is a bit tricky.
This is not volatility that is posted by the underlying but the volatility that is expected of the underlying during the life of the Option.
We don’t need to worry about calculating it since we already know the answer i.e. Option Premium. But, with the given Option Premium and 4 known factors we can definitely find out the Volatility Implied by the Premium by back calculation.
Thus, found Volatility from given Premium is called Implied Volatility.
Relationship: Impact of IV is fairly straight forward with Options being priced mathematically. Higher the Premium at a point in time and at price point in the Underlying, Higher will be the IV.
Higher IV >> Higher Expected Volatility
This helps with the relationship again (it is which came first Egg or Chicken dilemma).
Higher Expected Volatility >> Higher IV >> Higher Premium
Lower Expectation of Volatility >> Lower IV >> Lower Premium
This relationship is very vividly visible during the times of results. Most of us must have seen this. Right after the Result of a company (which is expected to bring unknown development) we see all Options (Calls and Puts) premiums fall.
This is the reduction in Expected Volatility since the unknown is over and hence the Premiums fall. The reason for this is Fall in Expected Volatility or Fall in IV.
One more thing we should keep in mind is that Rise or Constructive move is always slower than the Fall or Destructive move. Hence, when there is no event in sight, we can easily observe that Rising Market has Falling IV and Falling market has Rising IV.
Actionable: Remember the relationship Rise in IV >> Rise in Premium and Vice Versa.
For a market turnaround trade I should be prepared that IV may fall with a constructive move and thereby the Premium may also fall due to a fall in IV.
So, I will try and trade Options in Spread, Buy a Call and Sell a Higher Strike Call while trading a market turnaround to safeguard myself from a fall in premium due to fall in IV.
Similarly, I should be careful in holding on to Buy Option position when the Result is announced, because there may or may not be a movement in the underlying but there will definitely be a fall in premium due to end of the unknown event.
IV also has an analytical aspect but that is a separate discussion altogether. One must know that there is a significant aspect of IV a.k.a. expected volatility that impacts Option Premium. Hope this explains what the impact is and how to provide for it.Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.