Understanding, Applying, and Evaluating Implied Volatility in Options Trading: A Step-by-Step Guide

Volatility In Options Trading

Volatility is one of the most important concepts to understand when trading options. Many traders starting out in options trading believe that their familiarity and experience with the underlying asset, whether equities or commodities, will transfer to success in options trading. Being competent in the analysis of the underlying asset, whether through fundamental or technical analysis, provides the basis for understanding the underlying asset price movements but misses out on a crucial component when trading options: volatility.

Volatility is the percentage that measures the amount by which the underlying stock or asset is expected to change in a given time. There are various volatility measures in options trading, as these measures play a vital role in options pricing, risk assessment, and appropriate trading strategies.

Historical Volatility

Historical volatility refers to an asset's past price movements, measured over a specific period. It looks at the standard deviation of price changes, typically daily, and expresses how much the price of the underlying asset has fluctuated during that period. Historical volatility is helpful as a baseline measure of how volatile the asset has been. Although historical volatility is a measure of the past and does not predict the future, traders may use this data to compare with implied volatility to determine whether the market is pricing in more or less volatility than has been experienced.

Implied Volatility

Implied volatility is what the market is implying now. Implied volatility is derived from the current prices of options using pricing models such as Black-Scholes and represents the expected price movement as implied by the option's premium (price)

Future Or Expected Volatility

Future or expected volatility is required in the Black-Scholes options pricing model. However, the main challenge with future volatility is that it is unknown and cannot be directly observed. Traders attempt to estimate this measure, and these expectations are embedded in the prices of options, giving rise to implied volatility.

Pricing Options- Black-Scholes Model

The Black-Scholes Model is the most universally used model by traders for calculating the value or price of an option. The model is easy to use and requires only five (5) inputs in the formula: -

1. The price of the underlying asset or spot price

2. The strike price of the option

3. The risk-free interest rate

4. The time to option maturity or expiration

5. The expected future volatility

The first four inputs can be determined quickly, except for the last, expected future volatility. Since no one can predict future volatility, traders largely gauge this input using implied volatility.

Fundamentally, implied volatility reflects the anticipated volatility of the underlying asset over the option's life. It is a forward-looking measure derived from option prices, indicating the market's consensus on the magnitude of price changes rather than the direction. Supply and demand in the options market drive implied volatility; as traders bid up option premiums, implied volatility rises, and when option demand declines, implied volatility falls.

An example of understanding the above price mechanics is that a highly volatile asset, say a stock, has a better chance of making a substantial move than a low-volatility stock. A more volatile stock would have more significant swings upwards or downwards in a shorter period than a less volatile stock. Therefore, the options of a high-volatility stock would most times command higher premiums.

Using the Black-Scholes Model, you can calculate the implied volatility from the current price of options. The formula will return the implied volatility by inputting the current price of the option, including the first four inputs above: the spot price, strike price, risk-free interest rate, and time to expiration.

You can check online options calculators based on the Black-Scholes and other pricing models like the Binomial model to evaluate the various inputs and scenarios they produce.

Buy Low, Sell High

Understanding implied volatility helps in pricing options and opens a range of strategies that traders can use based on their outlook for future volatility.

Buying Low Implied Volatility

When implied volatility is low, option premiums are generally cheaper. If you expect an increase in volatility, you can capitalize on this by purchasing options. For example, suppose you expect an increase in implied volatility with a corresponding rise or fall in the underlying asset's price. In that case, you can buy a call or put option.

Another strategy is a favourite of traders in scenarios where they anticipate significant price movement but are unsure of the direction; they can buy both a call and a put at the same strike price (a long straddle) or different strike prices (a long strangle). This strategy benefits from a rise in volatility, as both options increase in value when implied volatility expands, regardless of which direction the underlying asset moves.

Selling High Implied Volatility

Conversely, when implied volatility is high, options premiums tend to be expensive, making it conducive to selling options. In this environment, options traders look to short straddles or strangles, with the view that the high options premiums will shrink, allowing the trader to profit from the premium collected.

Alternatively, a trader can sell covered calls, a strategy where the trader holds the underlying asset and sells call options on the same asset. For example, an owner of stocks can sell call options on the same stock. This strategy is often used to generate additional income from the stock holdings through the premium received from selling the call option. The term "covered" call is because the option seller already owns the underlying asset, which "covers" the obligation to deliver the shares if the option is exercised.

Another strategy when premiums are high is the cash-secured put. The tradersells a put option and simultaneously sets aside enough cash to purchase the underlying asset if the put option is exercised. This strategy is used by traders who are willing to buy the underlying asset at a lower price than its current market value while collecting a premium for selling the put option.

Checking Fair Pricing of Options with Implied Volatility

One way traders can identify potential mispricing opportunities is by comparing implied volatility levels across similar assets or options with different expiration dates. When one does that, an option could be overvalued if one of the option's implied volatility is a lot higher than another with similar characteristics.

Another way to assess pricing fairness is to compare implied volatility to historical volatility. If implied volatility is significantly higher than the asset's historical volatility, the market may be over-exuberant with the potential for future price movements, thus overpricing the option. Conversely, if implied volatility is much lower than historical volatility, options might be underpriced.

Implied volatility mispricing creates numerous trading opportunities for options traders who can identify when options are overpriced or underpriced relative to historical norms, market expectations, or events.