Advanced Option Strategies/Education

Examining Implied Volatility
Andrea Kramer (akramer@sir-inc.com)

Sophisticated investors have been utilizing options for decades, hedging their portfolios and generating substantial gains in both bull and bear markets. However, these success stories didn’t happen overnight; prosperous option players first armed themselves with an artillery of knowledge. In order to ensure success in your options-trading venture, you must begin by familiarizing yourself with the ins and outs of these unique financial instruments.

One of the concepts important to options traders is notion of implied volatility.

Implied volatility (IV) is the market’s assumption of a stock’s future volatility based on the price of the stock’s options. In other words, the rise and fall of an option’s IV will determine how expensive or cheap an option is priced. Implied volatilities are of interest to traders, as they’re loosely based off a stock’s historical volatility and future expectations. Thus, looking at an option’s implied volatility is yet another way to gauge investor sentiment.

There are several variables that influence an option’s premium, and IV is a key component of the option pricing equation. An option’s implied volatility fluctuates as expectations for the underlying security change, and rises and falls in conjunction with the supply and demand of the option.

For instance, a stock that is expected to experience a large degree of price movement will have a higher IV, and will therefore have higher-priced options. A stock with escalating put demand would also drive the options’ price higher, increasing their implied volatility. On the flip side, as the market’s outlook for a stock decreases, or demand for an option subsides, implied volatility will diminish in parity. As a result of lower levels of IV, the option’s price will diminish.

However, keep in mind that IVs should be studied in the context of historical volatility readings and stock price movements if they are to be used efficiently as an indicator. On that note, an option’s implied volatility is best compared to the stock’s historical volatility for roughly the same time frame. For instance, a front-month option (with less than 1 month until expiration) should be juxtaposed with the underlying security’s 1-month historical volatility. Meanwhile, an option with 2 months until expiration should be sized up against the equity’s 2-month historical volatility.

Let’s say Company ABC’s front-month 10 call has been popular in the options pits recently, with escalating demand sending its implied volatility higher. Although the option’s new IV of 95% is greater than yesterday’s IV of 80%, it’s still less than the stock’s 1-month historical volatility reading of 105%. In this case, the price of the ABC front-month call is still relatively cheap on a volatility basis. On the flip side, if ABC’s front-month 10 call has an IV of 118% - higher than the stock’s 1-month historical volatility of 105% - the option is considered relatively expensive.

In conclusion, traders should consider an option’s implied volatility before making a move. Like with anything else you purchase, it’s smart to hunt for hot bargains – like an undervalued option. In addition, investors should keep an eye on the IVs in their portfolio, and recognize when an option is relatively expensive, as this could provide a profitable opportunity to “sell high.”

Furthermore, IVs can help options players measure the sentiment in the options arena. When a particular stock is moving higher, its put implied volatility generally decreases because investors feel less compelled to purchase puts as portfolio protection. Conversely, when an equity is trending lower, put implied volatility tends to increase due to the snowballing demand for put protection. Extreme readings like this can often mark key turning points, as investors will generally pay exorbitant prices for portfolio insurance during periods of intense fear. However, contrarians can capitalize on a low-expectation environment by getting in ahead of a potential rebound.




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