Implied Volatility & Option Trading



Implied Volatility Introduction


Option traders can never fully understand the dynamics behind pricing of stock options and stock option price movements without understanding what volatility and implied volatility are. Volatility is defined as "Tendency to fluctuate Sharply & Regularly" at dictionary.com. Hence the saying,"A volatile market". Volatility can be calculated mathematically to arrive at an expectation of the amount of volatility in the underlying asset or market implied by current price data, hence the development of Implied Volatility. Implied volatility is the second most important price determinant of stock options other than the price of the stock itself.

What Implied Volatility does is to estimate the underlying asset's possible magnitude of move to either direction. The higher the Implied Volatility, the more the stock is expected to move and hence a greater possibility that the underlying asset will move in your favor. The lower the Implied Volatility, the more stagnant the stock is expected to be and hence the lower the possibility that the stock will move in your favor.

As such, the higher the implied volatility of the underlying asset, the higher the extrinsic value of its options will be and the more expensive those options become due to a greater possibility that it will end up in your favor profitably. This dynamic is represented in the greeks of every option contract as the VEGA.



Factors Affecting Implied Volatility


Mathematically, the factors that affect implied volatility are the exercise price, the riskless rate of return, maturity date and the price of the option. These factors are taken into consideration in several option pricing models, including the Black-Scholes Option Pricing Model. Implied volatility is also the only variable that goes into a mathematical option pricing model.

In reality, implied volatility of options is determined by market maker's assessment of public expectations regarding events that might change the value of an option. In one sided markets, market makers are charged with the obligation to sell options to buyers in order maintain liquidity. They then increase the value of the options through increasing their assessment of implied volatility so as to reap a greater profit. Conversely, when the market is selling off options, these market makers charged with the obligation to buy from these sellers, lowers the price of the options through lowering their assessment of implied volatility.

OppiE's Note Many option traders are wondering who is buying the options when everyone is selling and who is selling the options when everyone is buying. In such one sided markets, option traders are actually dealing directly with market makers instead of another option trader.

This is also why implied volatility tends to rise in a bear market and drop in a bull market. In a bear market, investors and traders alike usually rush into put options for speculation or hedging purpose all at once while in a bull market, the buying of call options tend to be more spread out and less "hurried".



Charting Implied Volatility


Implied volatility of options of the same underlying asset and expiration date are often plotted to arrive at it's Volatility Smile or Volatility Skew. Volatility Smile or Volatility Skew of implied volatility allows option traders to not only tell at a glance which options are more expensive, but is also indicative of whether the underlying stock is expected to make big moves in the short run.





How To Profit From Implied Volatility?


Volatility, represented by the Implied Volatility, is slowly becoming a known asset class all on its own. You can buy and sell volatility and profit from it using various methods. For an option trader, when implied volatility is low and expected to increase over the next month, one could actually "Buy Volatility" by establishing an option strategy such as a Straddle on a stagnant stock. In this instance, as the position is "Long Vega" (price goes up as volatility goes up), the position will increase in price as implied volatility increases even without a move in the underlying asset.

Conversely, if implied volatility on that underlying asset is expected to decrease, one could actually "Short Volatility" by executing a Short Straddle, which is a "Short Vega" (you profit as volatility goes down) position. This is commonly what is used during periods of expected Volatility Crunch.

Advanced option traders may even construct positions that exclusively profits from changes in volatility. Examples are "Delta Neutral" positions, where small moves in the underlying asset do not affect the price of the overall position, and go long or short vega instead.

If one is interested in buying and selling the volitility of the market in general, one could simply buy and sell VIX options. The VIX is the ticker symbol for the CBOE Volatility Index. The CBOE Volatility Index shows the market's expectation of 30-days volatility and is constructed using the implied volatilities of a wide range of S&P 500 index options. If one expects implied volatility to go up, one could simply buy a call option on the VIX the very same way one would buy a call option on stocks that are expected to rise. If one expects implied volatility to go down, one could simply buy a put option on the VIX the very same way one would buy a put option on stocks that are expected to fall. Advanced option traders may even execute all kinds of option strategies using VIX options in the very same way one can for a stock and could even buy put options or write call options as a hedge against a drop in volatility if your option position is long Vega. In this sense, volatility truly becomes an asset class of its own.

You can get daily VIX chart from our Option Trader's HQ free!

OppiE's Note The CBOE Volatility Index (VIX) was created by the Chicago Board Of Exchange in 1993. It started out incorporating only 8 S&P 100 at-the-money call and put options. Now, ten years later, CBOE switches to the S&P500 index so as to capture a broader segment of the overall market in order to better reflect general investor sentiments. VIX is sometimes referred to as the "investor fear gauge" because it has a tendency to rise sharply when markets are under stress and falls to low levels when markets are smooth and steady. However, VIX does not measure sentiment, it only measures implied volatility. Since implied volatility is most significantly affected by changes in actual volatility and actual price data, the rise in VIX during periods of market stress is not a result of investor sentiment, but to the increase in actual volatility.





How Is Implied Volatility Calculated?


One can solve for the implied volatility in the price of an option through working the Black-Scholes model in reverse. Please read more about the Black-Scholes Model here.
You can also find an implied volatility calculator at Ivolatility.com



Implied Volatility Formula


This formula allows you to work out the implied volatility that has already been factored into the price of an option. It is not a formula to determine the implied volatility of an option from scratch.



xi = Volatility

vi = optionís Vega at theoretical value yi

yi = optionís theoretical value at volatility xi

p = option price



Option Strategies For Trading Implied Volatility On Stocks


There are only 2 opinions on implied volatility from which you can hope to profit from trading volatility of stocks. Bullish or Bearish. Period. Listed here are some option trading strategies you can use to profit from both views.

Bullish On Implied Volatility
These option strategies allows you to profit from an increase in implied volatility without any increase in the stock.
Long Straddle
Long Strangle
Short Condor
Short Butterfly
The perfect strategy to profit from a bullish view on volatility has to be through the use of Delta and Gamma Neutral Hedging.

Bearish On Implied Volatility
These option strategies allows you to profit from a decrease in implied volatility without any decrease in the stock.
Short Straddle
Short Strangle
Long Butterfly Spread
Long Condor
Ratio Spreads

OppiE's Note When you wish to trade the volatility of the market in general, you would simply buy a call or put option on VIX. You could also use bullish or bearish option strategies on the VIX options. In general, when trading volatility, you are merely trading the implied volatility numbers which affects the price of the option.




Questions Regarding Implied Volatility



:: "How To Trade Volatility Through Index Options?"


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