You may or may not be a seasoned options trader, but the concept of implied volatility (or “IV”) is essential to understand. Implied volatility measures the market’s expectations for price movements in a security and plays a crucial role in pricing options. This article will tell you all you need to know about IV: what it is, how it works, how to measure it, and how traders generally look at it before opening or closing a position. What does implied volatility mean in options?
Key takeaways
- Implied volatility is a measure of the market’s expectations regarding potential price movements in a security.
- It plays a crucial role in pricing options, with higher IV leading to increased premiums, influenced by supply and demand as well as time value.
- The IV Rank (or IV Percentile) is a good way to measure how high or low an option’s implied volatility is compared to the past.
Implied Volatility Meaning
So, what is implied volatility? Implied volatility (IV) is the market’s forecast of a security’s price movement over a specific period, expressed as an annualized percentage. Essentially, it reflects how much the price of an asset might swing in the coming year.
So, what does implied volatility mean in options? IV estimates the annualized expected move in a security’s price. For example, if a stock has an implied volatility of 20%, it means the market expects the stock to move up or down by 20% over the next year.
Derivation from Market Prices
Unlike historical volatility, which looks at past price movements, implied volatility is derived from current market prices of options. It reflects the collective expectations of traders about future price fluctuations. Technically, there are two main things you should know about how IV is derived:
- Options Pricing Models: IV is calculated using models like Black-Scholes and Binomial, which incorporate multiple factors such as the current price of the underlying asset, strike price, time until expiration, and interest rates. These models solve for IV by reverse-engineering the market price of options.
- No Fundamental Analysis: Calculating IV does not rely on fundamental analysis, such as earnings reports or economic indicators. Instead, it’s purely based on the current pricing in the options market.
Why Should Options Traders Care About IV?
IV provides insights into the market’s expectations for future price movements. Higher IV suggests larger expected price swings, while lower IV indicates more stable prices. Here is a synthetic table of what you should keep in mind:
Supply and Demand
Increased demand for options leads to higher IV and thus higher premiums. Think of it this way: the higher the market expected price movement of an underlying asset, the higher investors will speculate on options. For instance, before an earnings report, some will buy OTM calls, while others will aim for OTM puts (and some may buy both). The result will be an increase in implied volatility in options, which will likely convert into a large volatility spike in the underlying price following the earnings report (notice how the increase in IV anticipated the increase in historical volatility).
Low demand and low speculation over options will likely push implied volatility down, together with the options’ premium. This is, generally, what happens after an earnings report with a sudden collapse in IV (“IV Crush”).
Strategic Decisions
Traders make strategic decisions based on IV:
- High IV: Sell options to collect higher premiums.
- Low IV: Buy options to potentially benefit from future increases in volatility. The meaning of implied volatility here is clear: IV can act as a bullish driver for option prices.
More Aspects to Consider
- Risk Management: Traders use IV to gauge whether options are relatively expensive or cheap. For example, when IV is low, buying options can be cheaper, whereas selling options can be more profitable when IV is high.
- Market Sentiment Gauge: IV in options acts as a measure of market sentiment. Rising IV typically indicates heightened uncertainty or fear, while falling IV suggests increasing confidence and stability.
How Does Implied Volatility Work? (and Its Effects on Options)
We can now go beyond the definition of implied volatility in options and try to better understand how IV actually works. We’ll spare you the math, but here are the essentials:
Market Expectations and Pricing
- Forward-Looking Measure: Implied volatility (IV) measures the market’s expectations for future price movements of an asset. Unlike historical volatility, which looks at past price changes, IV is forward-looking.
- Options Pricing Models: IV in options is calculated using models like Black-Scholes, which consider factors such as the current price of the underlying asset, strike price, time until expiration, and interest rates.
- Fair Pricing: Traders use implied volatility to assess whether options are priced fairly. A higher IV indicates more expensive options, while a lower IV suggests cheaper options.
Market Sentiment and Risk Management
Another essential aspect to consider is that IV serves as a barometer for market sentiment, reflecting fear and uncertainty. When markets are stable, IV is low; during times of uncertainty, it spikes.
Uncertainty is not necessarily bad: we told you how earnings reports recurrently move IV – in a way, this means that the market is “uncertain” about what are the actual results of the earnings report. However, when this happens on a large group of stocks (i.e., an index) at the same time, things begin to go south.
In this context, thinking about the “VIX” or CBOE Volatility Index can help. The VIX is a prominent measure of IV for S&P 500 options and is often seen as a “fear gauge,” indicating potential market shifts during stress, here is how it works:
Investors tend to see a VIX reading above 30 as a sign of an unstable market. In contrast, readings below 20 are typically seen as a more stable environment.
Strategic Trading Decisions
Can you trade IV? Absolutely. It is not easy, but it can work. Some traders capitalize on changes in IV by buying options when IV is low and selling when IV is high. The strategy may fail because IV is not the only component of an option’s price (more info on this in the next section). In summary, this is how it works:
- High IV Strategies: In high IV environments, shorting options can be more profitable due to higher premiums. This is because increased demand for options leads to higher IV and thus higher premiums.
- Low IV Strategies: Conversely, in low IV environments, buying options can be cheaper, making it a good time for long premium strategies.
Practical Applications
- Options Pricing: IV directly impacts options pricing. Higher IV leads to more expensive options, while lower IV results in cheaper options.
- Investment Strategies: Traders can optimize their strategies by understanding IV trends. For instance, during periods of high IV, selling options might be more rewarding due to higher premiums.
- Managing Expectations: By analyzing IV, traders can set realistic expectations for potential price movements and adjust their positions accordingly.
The Different Options Pricing Models
Whether you are trading American-style or European-style options, understanding the different pricing models is essential. Here is a quick comparison between the two main pricing models:
Black-Scholes Model
The Black-Scholes model is one of the most widely used methods for pricing European-style options. It provides a theoretical estimate of an option’s price based on several key inputs:
- Current Stock Price: The current market price of the underlying asset.
- Option’s Strike Price: The price at which the option can be exercised.
- Time Until Expiration: The remaining time until the option’s expiration date, usually expressed as a fraction of a year.
- Risk-Free Interest Rates: The theoretical rate of return on an investment with zero risk, often based on government bonds.
- Underlying Volatility: A measure of the underlying price volatility over time.
The model assumes that the price of the underlying asset follows a lognormal distribution, and it uses these inputs to calculate the option’s fair value. It’s primarily used to price European-style options, which can only be exercised at expiration.
The Black-Scholes model helps traders determine whether options are fairly priced by comparing the model’s output to the market price. One of its key outputs is the implied volatility, which provides insight into the market’s expectations for future volatility. By understanding what implied volatility is and how it influences options pricing, traders can make more informed decisions.
Binomial Model
The binomial model takes a stepwise approach to modeling price changes of the underlying asset. It breaks down the time to expiration into multiple intervals, creating a decision-tree framework:
- Decision-Tree Framework: At each interval, the model assumes that the price of the underlying asset can either move up or down by a specific factor.
- Probabilities: The model assigns probabilities to each possible move, creating a tree of potential future prices.
This stepwise approach allows for greater flexibility in modeling various paths an option’s price might take. The binomial model is particularly useful for pricing American-style options, which can be exercised at any time before expiration. This versatility makes the binomial model suitable for options that require complex pricing considerations.
The model also incorporates implied volatility to estimate the option’s price. Understanding implied volatility in options and how IV influences the binomial model helps traders grasp the potential range of future price movements and make informed decisions about their trading strategies.
A Real-Life Implied Volatility Example
We told you what implied volatility is, but a couple of examples on IV (and on how to read it) will surely clarify its practical application. Our options screener provides both the classic implied volatility value and an indicator called implied volatility rank (IV Rank). It’s challenging to determine whether an option’s IV is high simply by looking at its value. The best way to analyze this number is to compare how high (or low) IV is relative to the past. This is where the IV Rank comes into play.
Understanding IV Rank
- IV Rank: Measures how expensive or inexpensive the IV is compared to its historical range.
- Example: If a stock has an IV Rank (or implied volatility percentile, if you prefer) of 98%, it means that 98% of the days in the past year had lower IV than the current level. Simply put, the current IV in options is high.
Let’s break down two real-life examples: Crowdstrike (CRWD) and Bank of America (BAC).
Example 1: Crowdstrike (CRWD)
If we look at CRWD, we can see how the implied volatility in options (the green line below) has recently moved up:
Here is how we would normally read this chart:
- Current IV Rank: 92.86%
- Analysis: CRWD’s high IV Rank suggests that the implied volatility is significantly elevated compared to its historical levels. This high IV rank indicates that CRWD options are likely overbought. For options sellers, this is advantageous because the high IV implies higher premiums. As IV typically mean-reverts, selling CRWD options now could be beneficial if the IV decreases, leading to a decline in option premiums.
- Consideration: What does implied volatility mean in options when we look at CRWD? While IV is not the only factor affecting an option’s price, it is crucial. High IV reflects market uncertainty or anticipated significant price swings, making it a valuable metric for options traders.
Example 2: Bank of America (BAC)
We want to give you the opposite case as well as an example, and BAC gives us a nice occasion to do this (again, focus on the green line):
When looking at this chart, this is what we see:
- Current IV Rank: 9.52%
- Analysis: BAC’s low IV Rank indicates that the implied volatility is quite low compared to its historical range, suggesting that BAC options are currently inexpensive. For options buyers, this scenario might be appealing as the cost of acquiring options is lower. Additionally, if IV in options increases, which is likely due to the mean-reverting nature of volatility, the value of these options could rise, leading to potential profits.
- Consideration: The meaning of implied volatility is quite clear in this example. Buying BAC options when IV is low can be strategic, especially if you anticipate future volatility increases. Low IV environments are generally more stable, but any uptick in IV can enhance the value of the purchased options.
Practical Implications
- For Sellers: High IV environments, like that of CRWD, offer higher premiums and potentially greater returns. Selling options in such conditions, anticipating a drop in IV, can be a profitable strategy.
- For Buyers: Low IV environments, as seen with BAC, present opportunities to buy options at lower costs. If the market anticipates future price swings, the value of these options may increase, providing a good return on investment.
Pros and Cons of Implied Volatility in Options
There are some positive and negative aspects about IV. We would not recommend basing a trade entirely on IV, as a result of the pros and cons below. However, ignoring IV in options can lead to missed opportunities or entering the right trade at the wrong time. Let us summarize the pros and cons of IV in the table below:
Pros
- Measures Market Sentiment and Uncertainty: Implied volatility helps to quantify market sentiment and uncertainty. It provides traders with an estimate of how much an asset’s price might move, giving them a sense of the market’s expectations.
- Essential Aspect to Understand Option Prices: Implied volatility is crucial in setting options prices. Higher IV leads to higher premiums, making it essential for accurately pricing options contracts. This allows traders to gauge whether options are fairly priced.
- IV Can Guide Option Strategies: Traders use implied volatility to guide their trading strategies. For example, high IV might suggest selling options to capitalize on higher premiums, while low IV could indicate a good time to buy options at lower costs.
Cons
- IV Ignores Fundamentals: Implied volatility in options is based solely on market prices rather than the fundamentals of the underlying asset. This means it reflects market sentiment but does not provide insights into the intrinsic value of the asset.
- IV Can Change Quickly following News or Events: IV is highly sensitive to unexpected factors and news events, such as earnings announcements, geopolitical events, or natural disasters. These events can cause sudden spikes or drops in IV, making it unpredictable.
- IV Doesn’t Predict Price Direction: While implied volatility estimates the magnitude of potential price movement, it does not indicate the direction of the movement. This means traders need to use additional tools to predict whether the price will go up or down.
Understanding Implied Volatility vs Historical Volatility
Understanding the nuances between implied volatility and historical volatility is essential for any options trader aiming to make informed decisions. Here is a table summarizing the main differences between implied volatility and historical volatility:
Implied Volatility
Implied volatility (IV) is a forward-looking metric that estimates the expected magnitude of price movement for an asset over a specific period. Unlike historical volatility, which looks at past price changes, IV is concerned with future expectations. It helps quantify market sentiment and uncertainty, estimating the size of the movement an asset may take without indicating its direction.
Market Expectations and Perceptions of Risk
Implied volatility in options incorporates market expectations and perceptions of risk. Derived from current market prices of options, it reflects the collective sentiment of investors about the future volatility of an asset. When investors expect significant price swings, IV in options tends to be higher.
Influence of Investor Sentiment and Future Events
Investor sentiment and anticipated future events heavily influence IV. For instance, upcoming earnings reports, geopolitical events, or economic data releases can cause spikes in IV as traders anticipate potential market-moving news. Adverse events like wars or natural disasters may also impact implied volatility. IV is dynamic and can change rapidly in response to new information, making it a crucial tool for gauging market sentiment.
Historical Volatility
Historical volatility (HV) (or realized volatility, RV) measures the actual price movements of an asset over a past period. It is calculated by analyzing the standard deviation of the asset’s returns over a specific timeframe. This provides a statistical measure of its past volatility and helps traders understand the asset’s typical price behavior.
Quantifying Historical Price Variation
Historical volatility quantifies historical price variation, offering insights into how much the asset’s price has fluctuated in the past. This historical context allows traders to assess the risk profile of the asset based on its previous performance.
Comparing Predictive Use of IV vs. Historical Measurement of HV
While implied volatility is forward-looking and based on market expectations, historical volatility is backward-looking and based on actual past price movements. IV is used to predict future volatility and set options prices, while HV provides a historical context for an asset’s price behavior. Traders often compare IV and HV to identify discrepancies and potential trading opportunities. For example:
- High IV vs. HV: If IV is significantly higher than HV, it may indicate that the market is expecting more volatility than what has been observed historically. This could present a selling opportunity for options traders, as higher IV typically leads to higher premiums.
- Low IV vs. HV: Conversely, if IV is lower than HV, it may suggest that the market is expecting less volatility than usual. This could be a good time to buy options, as lower IV usually results in cheaper premiums.
A final note on IV vs HV: go back to our examples above. You’ll notice that the two images we added show two lines, a green one and an orange one. We told you to focus on the green one, which indicated the IV, but now you can look at the orange one as well (which indicates the HV) and compare the two. Note two things:
- IV tends to anticipate a change in HV
- However, the previous anticipation rule is not always true. Some exceptions exist, and the cause of this discrepancy deserves a deeper explanation. For the sake of this article, just remember this: IV helps understand the magnitude of expected changes, while HV represents the actual changes that have occurred. Both metrics are essential for informed options trading.
How to Use Implied Volatility
At this point, we are ready to determine how to effectively use implied volatility in options trading. Here’s a straightforward approach:
- Assess Implied Volatility Levels: Start by identifying whether the implied volatility for a specific option is high or low relative to its historical levels. This can be gauged using metrics like IV Rank (or implied volatility percentile).
- Research Premiums: Understand why some options have expensive premiums. High implied volatility usually leads to higher premiums because the market anticipates significant price swings.
- Identify Selling Opportunities: Look for options with high implied volatility as potential selling opportunities. High IV suggests higher premiums, which can make selling options more profitable. This strategy works well if you expect the IV to decrease over time.
- Identify Buying Opportunities: Conversely, identify options with low implied volatility as potential buying opportunities. Lower IV means cheaper options, making it a good time to buy if you anticipate future increases in volatility.
By leveraging implied volatility, traders can make informed decisions about when to buy or sell options, optimize their strategies, and potentially improve their returns. Understanding what implied volatility is and means in options helps in assessing market sentiment, managing risk, and timing trades effectively.
