Updated: Apr 8, 2021
Welcome to a brand new and one of the most important articles regarding the options trading strategies. Let’s quickly recap what we had learned so far. In the previous article, we had learned about the options premium. What are they? What is the relationship between premium and Implied volatility (IV)?
Now, we are talking about IV. As you know that we had talked about the IV in our previous articles but now, let’s understand it comprehensively.
IV is a parameter to measure the risk in options trading. As we know that options, whether used to make sure a portfolio, create income or stock price movements, give the advantages over other financial instruments.
Various variables influence an option's strike price you can say the option’s premium. IV is the major ingredient to the option-pricing equation, and the success of an options trade can be outstandingly enhanced by being on the right side of implied volatility changes.
Implied volatility is a metric that expresses the market's view of the probability of changes in a given strike price. Investors can use it to predict future moves and supply and demand and often engage it to the options contracts.
First thing you need to understand that Implied volatility (IV) is one of the most important concepts for options traders to know for two reasons. First, it gives a hint of how volatile the market might be in the future and the second is that implied volatility can help you calculate probability.
This is a serious component of options trading which may be helpful when trying to find out the possibility of a stock reaching a specific price by a certain time. Keep in mind that while these reasons may give you a clue when making trading decisions, implied volatility does not give a forecast for market direction.
Implied volatility can be found out by using an option pricing model. It is the only factor in the model that isn't directly visible in the market. Instead, the mathematical option pricing model uses other factors to find out implied volatility and the premium of the options.
The Black-Scholes Model, a largely used and well-known options pricing model, the ingredient in current stock price, option’s strike price, time until the expiration date (written as a percent of a year), and risk-free interest rates.
The Black-Scholes Model is very fast in calculating any number of option prices. However, it cannot correctly find out American options, since it only takes the price at an option's expiration date. American options are those that the owner may exercise at any time up to and as well as the expiration day.
Just as with the market as an entire, implied volatility is subject to uncertain changes. Supply and demand are the main determining factors for implied volatility. When an asset is in high demand, the price goes up. So does the implied volatility, which guides to a higher option premium due to the risky nature of the option.
The opposite is also the truth. When there is enough supply but not enough market demand, the implied volatility goes down, and the option price becomes cheaper.
Another premium affecting factor is the time value of the option, or the amount of time until the option expires. A short-dated option mostly results in low implied volatility, whereas a long-dated option mostly goes to results in high implied volatility. The difference puts down on the amount of time left before the expiration of the contract. Since there is a bigger time, the price has an enlarge period to move into a favorable price level in comparison to the strike price.
Implied volatility indicates the market’s opinion of the stock’s potential moves, but it doesn’t predict direction. If the implied volatility is high, the market believes the stock has potential for large price swings in either direction, just as low IV shows the stock will not move as much by option expiration date.
To the traders who trade in an options contract, implied volatility is more crucial than historical volatility because of IV factors in all market assumptions. If for example, the company scheme to declare earnings or expects a major court ruling, these factors will affect the implied volatility of options that will expire on that same month. Implied volatility helps you find out how much of impact news may have on the underlying stock.
How can option traders use IV to make more knowledgeable trading decisions? IV offers an objective way to test predictions and identify entry and exit points. With option IV, you can find out an expected range – the high and low of the stock by expiration date. Implied volatility shows you whether the market agrees with your forecast, which helps you measure a trade’s risk and potential reward.
One more concept is IVR (IV Rank) and IVP (IV Percentile). Now, let’s discuss them. Implied Volatility Percentile (IVP) or Implied Volatility Rank (IVR) are two terms that can be used to track historical volatility. Using these tools will give you a hint of where the current IV number is in relationship to what volatility has been in the past.
When you are comfortable to use the relationship of the current implied volatility and compare it to historical volatility by using either IV percentile (IVP) or IV rank (IVR), you will have an extra margin in your trading for many strategies.
When you compare IV to IVP or IVR, it is important to use IVP or IVR consistently. Just compare the current IV to both IVP and IVR can tends to uncertainty. It is advisable to either use IVP or IVR. Using IVP for the first time and IVR the next time is not suggested. Stay consistent with your ideas. In my opinion, I prefer IVP over IVR.
When you look at the implied volatility (IV) of an option, it is giving you an idea of the current IV. It is important to know the relationship of the current volatility to the past historical volatility. This will help to find out what type of trading strategy to use when you enter a trade.
So, hopefully, by now you have a better idea of how useful implied volatility can be in your options trading. Not only does IV give you an idea of how volatile the market may be in the future, but it can also help you to find out the possibility of a stock reaching a specific price by a certain time. That can be essential information when you’re choosing specific options contracts to trade.