Volatility influences options prices because dramatic price swings amplify gains and losses. While traders can’t look at a crystal ball to see how much volatility the market will endure, implied volatility attempts to make this prediction. Implied volatility measures the anticipated volatility the underlying stock will experience from now until the option’s expiration. Analyzing implied volatility before entering or exiting options lets traders assess a key risk factor before buying options.
Understanding Implied Volatility (IV)
Every stock goes through volatility. Sharp price movements become frequent during high volatility, while a stock’s price tends to stay flat during low volatility. A stock can go through periods of high and low volatility throughout the option’s duration. Implied volatility predicts how much volatility a stock will go through during the length of the contract. A high implied volatility will result in a higher premium, while a low implied volatility translates into a more affordable option.
Difference Between Implied Volatility and Historical Volatility
Implied volatility aims to predict what will happen in the future. Historical volatility lets traders look at previous stretches of volatility. Some traders look at historical volatility and look for patterns. Reanalyzing past events and looking for present commonalities can help traders decide whether implied volatility is fair, too high or too low.
How Implied Volatility (IV) Works
Implied volatility (IV) helps traders assess the underlying stock’s price movement during the life of the options contract. It also impacts options prices. Some options trading apps provide implied volatility for you, so you don’t have to calculate it on your own.
How Implied Volatility Affects Options
Implied volatility isn’t the only factor that impacts options prices, but you can expect higher options prices if IV increases. When IV decreases, an option’s value decreases. Some traders avoid holding onto options right before earnings reports because of IV crush. IV crush is a term that describes an option contract’s implied volatility significantly decreasing after earnings get released. IV crush is why some options contracts lose value after an earnings report, even if the stock moves in a favorable direction for the contract.
Implied Volatility and Option Pricing Models
Most traders don’t have to worry about running manual calculations for implied volatility. But knowing the two options pricing models can help you learn more about options and have a deeper appreciation of what goes into IV. Knowing the inputs for these calculations can make you a better options trader.
Black-Scholes Model
The Black-Scholes Model is a time-tested options pricing model that was established in 1973. The model uses several inputs to arrive at an option’s price. The main calculation is below, but it breaks into several layers.
C = S * N (d1) - Ke^(-rt) * N (d2)
C = call option price
S = stock price
N = normal distribution
D1 and D2 values will get discussed later
K = strike price
E ~ 2.72 (irrational, infinite number like Pi)
R = risk-free return
T = time to maturity
D1 and D2 have separate equations you have to solve first before solving for the option price.
SD = standard deviation
D1 = [ln(s/k) + (r + SD ^(2/v) / 2) * t] / (SD √t)
D2 = D1 - SD √t
After solving for d1, you can then solve for d2. After having both of those calculations, it’s possible to solve for the option price. The Black-Scholes Model does not consider dividends in its calculation. It also does not anticipate the option getting exercised before the expiration date. You can do calculations yourself or use an options trading app that solves this formula for you and does all of the legwork.
Binomial Model
Binomial models use a binomial tree to help traders arrive at valuations for options contracts. This model is more popular than the Black-Scholes Model and tips traders off on the variation of options prices as expiration gets closer.
Each day is measured as a step. An option can gain or lose value within a day, and binomial trees provide estimated values for both scenarios. A $30 stock may experience a $1 step in either direction. The binomial model branches out and presents $29 and $31 as two scenarios based on the $1 step. The $29 and $31 price points are both nodes on the binomial model. Branching them out further can help traders determine the probability of an option reaching any price point. This information can help a trader determine their likelihood of profitability and when to enter or exit a position.
Factors that Make Implied Volatility Go Up or Down
Several factors influence implied volatility, including market conditions, demand for the stock and volume. Market sentiment is a driving force that determines implied volatility. An upcoming earnings report or regulatory announcement can spike up implied volatility leading up to the announcement. Once that news gets revealed, implied volatility decreases because there is less uncertainty.
Pros and Cons of Using Implied Volatility
Implied volatility can guide your options trading strategies. Here are some of the advantages of this useful metric:
- High volatility can imply it’s better to sell the option or wait until it gets lower.
- Lower implied volatility may present itself as a buying opportunity.
- IV tips traders off on how market participants feel about the stock.
Every investment opportunity has pros and cons. It’s a good idea to keep these disadvantages in mind and consider investment risks before using implied volatility:
- Surprises in the market can significantly increase or decrease volatility without much time to prepare.
- Implied volatility ignores fundamentals.
- High volatility does not help traders predict whether a stock will go up or down.
How to Use Implied Volatility to Your Advantage
Implied volatility can help traders determine whether to buy or sell options. Higher implied volatility elevates options prices and can make selling options more desirable. Traders can use this opportunity to collect higher premiums. Some traders may wait for implied volatility to decrease before closing their positions instead of waiting for the contract to expire worthless.
Options trading doesn’t offer any guarantees, but knowing the implied volatility can help you trade in the direction that increases the likelihood of profiting from the position.
Using IV for Your Options Trading
Implied volatility is one of several metrics that can improve your options trading. Traders use several data points and follow the news before entering and exiting positions. Using IV alongside other information may help you make more informed decisions with your options trades.
Frequently Asked Questions
Is high IV good for options?
A high IV is good for people who bought the option contract beforehand, but it results in higher premiums for traders who want to start positions.
What IV is good for options buying?
IV is one of several components that determine whether an option is a good buy. Traders should look at fundamentals, news and other resources before deciding whether implied volatility represents a buying opportunity.
What is the normal range of implied volatility?
That depends on the stock or exchange-traded fund (ETF) you view. ETFs with assets spread across many sectors tend to have lower IVs than growth stocks with sharp price movements and high valuations.
About Marc Guberti
Marc Guberti is an investing writer passionate about helping people learn more about money management, investing and finance. He has more than 10 years of writing experience focused on finance and digital marketing. His work has been published in U.S. News & World Report, USA Today, InvestorPlace and other publications.