Options give us liberty to trade our bullish and bearish views at a premium which is fraction of their price. With Options we not only trade price of the stock but also trade volatility and time which are integral part of the Options Premium.
Volatility is one of the inputs to calculate Option Premium. Everyone would have their own input on volatility. So, instead of finding the right input, what we do is back calculate the volatility figure from market traded Option Premium. Thus, calculated volatility is called Implied Volatility, volatility implied by the Option Premium.
Since volatility is an input, change in its value also has an impact on the Option Premium. Unaware of it, we may get badly impacted by the changes. However, if we place ourselves right, we can make extra money out of it. Let us understand this in 3 steps.
1. What is the relationship of Implied Volatility with Option Premium?
Implied Volatility is the momentum input in the Option Premium. This is what defines how much of the expected move is priced into the Option Premium. We all know that Option Seller will always have an obligation to buy/sell the stock or index on expiry if they end up expiring in the money (stock expiring above Call strike or below Put strike).
More volatility means more momentum. This means more chances of Option Seller getting the obligation to Buy or Sell stock at a loss. To safeguard this, Option Seller will be hedging more, which will cost them more. This more cost due to more volatility will be charged to the Option Buyer.
Thus, Higher Implied Volatility = Higher Premium.
2. How to calculate impact of the relationship between Implied Volatility with Option Premium?
Vega, is the single word that quantified the impact of implied volatility. There is a straightforward definition of Vega. Vega is the amount of change in Option Premium for 1% change in implied volatility keeping both time and price in the stock/ index constant.
This is important because Vega especially in the beginning of the expiry with 10 or more days to expiry is a much bigger value. Just like option premium Vega also goes down with passage of time.
Vega can have a serous impact on your profits if not dealt with the right way. At the same time, it can make an extra buck as well.
3. How to monetize implied volatility?
This last step explains how to utilize the Vega in your favour by simply choosing the right trade for your bullish or bearish bias.
Implied Volatility moves in a range. So, if it is at 3-4 weeks high, it is likely to come down and other way around.
Choose to Sell Put instead of Buying a Call if the Implied Volatility of a stock is high. Here, if the Volatility drops by 2%, premium goes down by 2X Vega value of that option, making extra money.
Similarly, if the implied volatility is low, Buy Option. If implied volatility rise by 2%, the premium will rise by 2X Vega.
Implied volatility charts are available on option analytics apps, alternatively one can track India VIX to check high and low volatility.
Disclaimer: The views and investment tips expressed by 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.
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