In the world of options trading, there are several concepts that you need to master to trade options contracts. Having a better understanding of these concepts can help you when making business decisions. Implicit volatility (IV) is one of the metric options commonly used by traders. Dominating IV will help you understand the dynamics behind the price of options. Read on to find out what implicit volatility is, how it affects options, and how it works to measure the chances of a trade succeeding.
What is implied volatility (IV)?
Implicit volatility calculates the expected magnitude of future price changes of a security. It signals to the investor the probability of uneven changes in the price of the underlying value depending on the demand and supply of a specific option contract. In short, implicit volatility shows the volatility of the price of a security in the future.
Implicit volatility is one of the usual parameters determine the price of an option. Traders and investors can use IV to predict future stock movements and apply this information when setting the price of option contracts. Historical volatility is the second most popular metric traders choose. However, IV differs from historical volatility in that it provides insight into future market movements based on past market changes.
How does implicit volatility work?
The implicit volatility is fluctuation of the market price of the underlying value. You can use it to estimate the future price volatility of a stock based on several factors. IV is usually expressed annually.
Implicit volatility increases significantly during bearish markets when investors think that stock prices will go down over time. On the other hand, IV decreases during bullish markets when investors expect prices to rise over time. Bearish markets tend to be risky for most investors.
It is important to note that the implied volatility does not predict the direction in which the price change will go. For example, high implicit volatility means large price variation, but the price could range high, low, or even both. The low implied volatility indicates that the price will not make major unpredictable changes.
How does implicit volatility affect options?
Implicit volatility is one of the main factors influencing the price of options. Understanding how implicit volatility affects option prices is vital when buying and selling option contracts. Being on the right side of implicit volatility can significantly increase the success of an options trade.
Options are contracts that give you the right, but not the obligation, to buy or sell a security at a specific price and at a predetermined time. To purchase an option contract, you must pay an option premium. As implicit volatility changes, option premiums change accordingly. Higher implied volatility means higher option premiums and vice versa.
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Factors affecting IV
Several factors influence the volatility implicit in options trading, the most common being:
1. Supply and demand
Supply and demand of the underlying stock directly influence the implied volatility. When there is a high demand for security, it will increase the implied volatility as well as the price of the security. Securities with high implicit volatility tend to have higher option premiums. Conversely, if security demand is low, the implied volatility decreases, leading to a lower premium for the options contract.
The rise and fall of implied volatility due to security supply and demand determines the success of an options trade. For example, if you have options when the IV increases, the prices of the options will increase. When IV decreases, you can cause significant losses.
2. Value of time
Another factor that affects implicit volatility is the amount of time left in an option contract until it expires. If there is not much time left for an option to expire, the implied volatility would be lower. In contrast, a longer time leads to higher implicit volatility. Long-term options are often too risky for option sellers because there is a longer time for the price of the underlying assets to move toward the strike price.
3. Market status
Market events such as earnings announcements, product approvals, possible mergers and acquisitions, and other informational events may affect implied volatility. It is not uncommon to see implicit volatility increase before these events because there are many price movements. The demand for option sellers to participate in these events raises the prices of options. However, the implied volatility may decrease after market events.
How to use implicit volatility to your advantage
Implicit volatility can give you an advantage by showing the probability that a stock will move up or down. This is great for quickly detecting changes in the market, but it also gives you a chance to reap some benefits. Here’s how you can use implicit volatility to your advantage:
Understand the standard deviation and the IV
Implicit volatility is the level of uncertainty about the future price of an option. When it comes to IVs, the standard deviation generally represents a 68.2% probability that a stock will reach a specific price range in a year.
Pay attention to the expected news
When a company is about to announce important news, the implied volatility changes accordingly. IV tends to increase during these periods and decrease once the actual events occur.
Pros and cons of implicit volatility
Like any other metric, implicit volatility has its own set of advantages and disadvantages.
- Quantify market uncertainty: Implicit volatility can quantify market uncertainty by estimating the price movement an asset can make.
- Determine the prices of the options: Implicit high volatility means higher option premiums, so the option price is more expensive. The opposite is also true; a low IV entails lower premiums for the options contract.
- Determine the business strategy: Implicit volatility can help investors make informed trading decisions. During periods of high IVs, investors can select safer investment options.
- Sensitive to market conditions: Unexpected market events, such as profit announcements and other news, affect volatility.
- Predicts price movements, but not direction: Implicit volatility only estimates future prices, rather than the direction in which prices will change.
- It does not adapt completely to reality: Because implicit volatility is based solely on prices, not fundamentals, it does not quite fit reality, as market prices are not distributed naturally.
Real life example
Implicit volatility is a measure of how much the price of an option will fluctuate over time. In other words, implicit volatility is the market prediction of the future movement of the underlying stocks.
One way to measure implicit volatility is by looking at the CBOE volatility index (VIX). The VIX is an indicator of short-term volatility market expectations. It is a weighted average of the stock options of the S&P 500 Index shares with a minimum duration of 30 days.
The graph above shows an example of IV and its range. Peaks indicate when implicit volatility is high, while troughs imply low volatility. If you look at the VIX chart, you can predict the price of the underlying options. For example, if you have a VIX option and IV increased, you can use this information to predict a future price drop.
Using IV along with other prediction techniques can help investors get the most out of their business. While there is no way to predict the future, understanding and using implicit volatility and other concepts can help investors maximize returns and manage risk.
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Frequently asked questions
Why is implicit volatility important?
How is implicit volatility found?
You can determine the implied volatility using an option pricing model. The Black-Sholes model is the most popular option price model, which takes into account the current stock price, strike price, interest rate, time to maturity and volatility.
How do the prices of option IV affect?
Implicit volatility is one of the most important factors in determining the price of an option. If there are changes in the implied volatility, the price of the options will change accordingly. As implicit volatility increases, so do the prices and premiums of options, and vice versa.
The end result
Implicit volatility is a valuable metric that is used when setting the price of option contracts. With IV, you can buy an option that tracks the price of the underlying value closer and has less risk than other types of options. This means that it is easier for investors and traders who are new to this financial instrument, as well as for experienced professionals, to manage their risks and make better decisions with their money.
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