Three Key Concepts of Implied Volatility
Apr 21, 2016
If there is a center around which all options trading revolves, it is implied volatility or IV. All our opening options trades begin with a simple question, “What’s the IV?” IV represents three things about a stock and its respective options:
Implied volatility is inversely correlated to its underlying asset. If the asset moves down in price, IV moves higher and vice versa. However, the relationship between IV and options is positive. When IV moves higher, the price of an option will move higher as well. In fact, if volatility is increasing quickly, it will become the dominant pricing component of an option. This is why we sometimes see call options increase in price when the price of its underlying asset falls quickly.
Using a hypothetical, let us assume ABC stock is trading for $100. If IV in ABC is 10%, that tells us the expected range over the next year is between $90 - $100. Should IV expand to 20%, then we know the expected range will now become $80 - $120. We are able to apply a variation of this to any time period, allowing us to better understand market expectations in an underlying asset over any time period of our choosing.
Implied volatility is often discussed in terms of fear. VIX, the CBOE Volatility Index for the S&P 500, is often referred to as the fear index. Here at tastytrade, we have a slightly different way of thinking about IV.
We do not see risk in terms of fear; rather, risk is where opportunities are found. Perception of risk is what causes IV to overestimate the percent by which an underlying will move, most of the time. When IV is very high, an already exaggerated expected move becomes more exaggerated. This is when option premium is most rich.
Implied volatility is present at the beginning, middle and end of options trading. Understanding its implications is crucial to understanding how options trade. The three key concepts discussed here are a good starting point but they are only a starting point.
Josh Fabian has been trading futures and derivatives for more than 25 years.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
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