Implied Volatility: It's critical, yet unknown, in Options, explains Shubham Agarwal

Options are always seen as complex instruments. However, if we look closely at the factors that determine the price of an Option instrument, the only factor that creates much of complexity is the factor of volatility.

Let us try to understand how.

What are the Option Price Determinants?

1. Stock/Index Price 2. Strike Price 3. Time to Expiry 4. Risk Free Interest Rate 5. Volatility of the Underlying

While the first four factors are straight forward and has absolute consensus over them, the figure of volatility is the only one that is tricky. Reason being the volatility figure that is input here is of the Expected Volatility of the stock/index during the upcoming life of the stock/index till the expiry date.

Now, we are not going to argue on or analyse how to predict this as the market does the job for us and price the options. However, the good part about it is that given the Option Premium and rest of the four factors we can now figure out what is the expected volatility priced into the market price of option.

Thus, extracted volatility figure, given the price of the option, is called Implied Volatility. In other words, it is volatility implied by the Option Premium traded in the market.

Now, let’s understand the importance of implied volatility with following three utilities

Primary Utility

Now that we know what implied volatility (IV, as it is popularly known) is, let’s understand that the Primary Utility of IV is to help create option pricing forecast.

The simplest way to forecast an Option Premium is by feeding the five factor values. Now to forecast premium at a different Stock/Index Price and after passage of certain time, we can feed in the factors as

Stock/Index Price = Forecast Price at which we want to find the Option Premium

Strike Price = Remains the Same

Time to Expiry = Time that remains for expiry after the forecast date of achieving such price

Risk Free Interest Rate = Remains the Same (Close to Zero)

Volatility = Current IV (Sophisticated Traders do alter this IV of the option as on now is a good input)

Analytic Utility

Now, for analytical purposes, IV has a very unique insight in its value. If the IV is in a rising mode that indicates the Option market participants are pricing in more expected volatility. More Volatility means more risk. Risk is associated with a Fall in Price (Asset Destruction).

So, as a value, if we plot IV on a daily basis and if we see it rising, that means that as an analytic, it is pointing towards a cautious outlook. On the other hand, if we see IV in a falling mode then it is analytically deciphered as pricing in of expectation of calmer times either an up move or consolidation.

Many Option Analytic applications now-a-days provide single IV value data for each stock/index. Generally, it is IV of option that belongs to nearest expiry and strike closest to market price of the stock/index.

Such IV index for the Nifty options is India VIX, published and made publicly available by the National Stock Exchange of India, that serves the same analytical purpose for forming a view on the entire market.

Trading Utility

Well, IV has its own rising and falling trend but is bound into a rather narrow range. It cannot go below zero and there is always an upper limit that it generally reacts from. Such oscillating characteristic makes it tradable for the range it holds (Sell at the Top of the Range and Buy at the bottom).

Selling IV at the Top is a bit tricky and is done by a lot of sophisticated traders but it requires specific skills as it involves option selling (Unlimited Risk - Limited Reward). So, let us leave it for another discussion.

But How do we Buy IV?

Higher IV = Higher Premium

To Buy IV without directional impact of the stock/index, buy both Call and Put of the strike closest to CMP of stock/index. If IV turns around and starts rising one would make money.

However, since options bought will be negatively impacted by passage of time. One needs to make sure that one does maintains a time stop loss of a few sessions and exit the trade if trade does not work out in 2-4 sessions.

Finally, there Books written on this subject of IV, so whatever we discuss is going to fall short but the utilities mentioned here do make a solid ground to pursue knowledge to monetize more out of this Critical Yet Unknown Fact about Option called IV.

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