Implied Volatility: Trusted bottom finder? Shubham Agarwal

In its descent from 26,000+, the Nifty fell meaningfully after a very long time. However, there is no indication where the fall will halt. Given that there was no meaningful correction in the recent past, finding a pivotal point is very difficult.

So, how about taking the help of options data?

The Implied Volatility (IV) is an options data point that can be used to calculate a bottom with reasonable probability.

But first, what is Implied Volatility? The  option premium (call / put) is made up of five variables, viz., the underlying price, strike price, time-to-expiry, interest rate, and volatility. With the first four factors being publicly available information, there is no debate on their input value.

However, the volatility may be calculated differently by different people. But  instead of debating over it, given that the option premium is a market-derived price, we can arrive at the volatility by feeding in the rest of the four variables and back-calculating the volatility for a given premium.

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Shubham Agarwal

CEO and Head of Research|Quantsapp Private Limited

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The IV is not the volatility of the stock derived from its historical returns, it is implied from the premium (hence the name). Apart from being a back-calculated figure, there is one more element which sets the IV apart from historical volatility.

Which is that the IV can be used as a proxy for a market consensus forecast volatility. The IV carries information not only about the characteristics of the stock or index’s  past movements, but also its future expectations. It is forward looking. Thus, IV is future volatility.

Before we start projecting a bottom, two important characteristics bear mention.

1. The range-bound nature of volatility. It moves in a range and does not trend like stocks.

2. Negative relationship with the stock or index. It falls when stocks rise, and rises when stocks fall.

These characteristics and the future expectation the IV carries gives an insight into a high-probability bottom zone. The following graph will indicate the practical implication of the IV and index relationship.

We can see that when the fall halted, we were at the 14.36 IV level. This level coincided with the recent top in early September 2024.

Remember, IV is range-bound, so it will try to find tops and bottoms in a narrower range. Secondly, it is reasonable to expect the previous top to be a turning point. Thus, the IV can help detect a probable bottom without needing to look elsewhere.

Lastly, the IV referred to here is the IV of the strike closest to the current market price of the Nifty. However, one may even use the NSE's India VIX with the  Nifty to draw similar observations.

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