How Implied Volatility Affects Option Prices

For traders and investors engaged in the options market, an understanding of the various forces that drive an option's value is critical. Among these forces is implied volatility (IV), an important forward-looking variable. Implied volatility (IV), while a simple term, should be regarded as a forecast (market-derived) of what the price of an underlying asset might do in the future; it is not a measure of past prices. Implied volatility is a measure of sentiment by the market; in short, it measures the willingness of traders to accept greater uncertainty or price extension by evaluating the future direction of price movement.

So, what is implied volatility and how does it affect an option's price? Imp implied volatility is a key input parameter in option pricing models, it is theoretically derived from an option's current market prices. Generally, if the market is anticipating the underlying asset will "move", or fluctuate a lot - either in the top or bottom direction - then the implied volatility tends to go up. The more option activity resumes near expiration and the more we expect movement from an underlying the more uncertainty is valued. If the market is somewhat established and does not seem to fluctuate much on either side, the implied volatility tends to decrease. Essentially, the relationship is pretty simple, general rule: the more costly the options, the more the implied volatility reflects the possible direction of price movement. Conversely, the less costly, the less important implied volatility plays a role in determining the value of an option or trade. Hence, there is a general knowledge surrounding implied volatility that every trader or investor should be aware of, particularly if they wish to assess risk and potential return. A deep grasp of what is IV in options is therefore essential for effectively trading options in volatile markets, as it works in tandem with other factors affecting option prices to determine an option’s value.

What is Implied Volatility?

To really understand its importance, we first must deal with the fundamental question: what is implied volatility? Implied volatility refers to the market forecast of the likely movement of an underlying asset and is forward-looking. Unlike historical volatility, which looks back at price movements on an underlying asset, implied volatility is based on the market price of an option. IV or implied volatility is the only variable in the Black-Scholes options pricing model that cannot be observed and is solved for by reversing the pricing model from the current market price of the option. Implied volatility helps traders evaluate market potential. Indicatively, higher implied volatility through option contracts suggests the market may be anticipating larger price movements, while lower implied volatility gives a firmer outlook and less risk of volatility. Thus, an understanding of implied volatility offers a background of trading conditions and market risk to traders. It does NOT offer a prediction of price direction, but an extent of movement that can be expected moving forward. Therefore, knowing what implied volatility is in regard to options is important to making informed decisions, particularly in an unstable market.

How Implied Volatility Affects Option Prices

The connection between implied volatility and option prices is robust and reliable. When implied volatility rises, more of the movement in the underlying price can reach or exceed the option's strike price before expiry. Because buyers of options can derive a profitable outcome based on the greater chance of price movement because of heightened volatility, the option value goes up, and the premium increases. When implied volatility is declining, the movement in the underlying does not exceed the implied volatility prior to expiry, and therefore there is no chance of profit based on the volatility. When volatility declines, an option buyer cannot derive potential profitable positions from options as the path is now pre-disturbed and unsuitable to produce profits, and the premium decreases. The degree to which implied volatility impacts option pricings is at the core of what option pricing is based on. Typically, a trader’s questions are; what is a good implied volatility for options? It depends on a trader’s strategy. Option buyers want lower IV, so they can purchase further out-of-the-money options for lower premiums with the hope of an increase in IV later. Option sellers are generally going to want higher implied volatility so they can sell expensive option premiums for the same reason, hoping for IV decline later in their expiry timeline. This is crucial.

What Are the Factors Influencing Implied Volatility?

Implied volatility levels are not static. They can fluctuate depending on numerous market and external factors. In a fundamental sense, implied volatility in the options market is a direct measurement of market sentiment. When fear or uncertainty is high, then demand for protective options typically rises, which will increase their premiums and thus their implied volatility. When markets are calm or the situation is stable, demand for protective options declines and subsequently implied volatility declines. Significant news events, like an upcoming earnings announcement for a company, or a release of important macroeconomic data, will create uncertainty in the marketplace. This uncertainty will create a situation where implied volatility for options will spike while traders assess a volatile price move. The laws of supply and demand apply here: a sudden influx of buyers for a specific option can immediately raise implied volatility.

How Does Implied Volatility Affect Options?

Implied volatility has a direct and significant effect on the price of an option, known as its premium. An option's premium is made up of two parts: intrinsic value and time value. Implied Volatility has a direct implication on the time component; ie. When IV is high it means the market is saying there is an above average chance of a big price swing, which then inflates the time component of the option's value, which means the cost of buying the option is more expensive. So as implied volatility declines, so does the time value of the option, which will make the option less expensive. The term often used to describe this phenomenon is volatility crush because an option’s actual value can decline even when the price of the underlying doesn't move. As traders, one of the more important things to know when it comes to trading options is what is a good implied volatility for options. For example, as option buyers, we generally want to see low IV so they can buy the option for less money, with the hopes that implied volatility increases. As In a seller of options, we would like to see high IV, so we can sell premium options at higher prices, with the expectation that IV would ultimately fall. This is the relationship that needs to be understood in order to make profits while trading options in volatile environments.

Interpreting Implied Volatility in Stocks

When implied volatility is mentioned with respect to stocks, it is recommendation of future price action for a particular stock. Higher implied volatility means near term expected movements of a stock price are going to be perceived as large, whether up or down. In terms of option trading, the market is seeing a heightened expected movement. This could be caused by various reasons including, earnings report, product announcement, or potentially big news announcement. Either way, the expected price movement increases the value of options on that stock because the underlying price has the potential move beyond the strike price. On the opposite end, lower implied volatility in options indicates the market expects the stock price to be trading relatively stable during that time period. This usually translates to lower option premiums. Traders are able to use this as a metric to gauge market sentiment and risk, allowing for potential movement, so they can decide to buy or sell an option.

Key Difference Between Implied and Historical Volatility

In order to assess the options market and price correctly, it is important to understand the difference between implied volatility and historical volatility. While both types of volatility assess the possibility of price movement, they look at things from two completely different perspectives. Historical volatility is a measure of the actual price movement of a security over a specified period of time in the past. It takes into account the past data of what actually happened, so it is factual and a past measure of how volatile a stock will be in the future. On the other hand, implied volatility is a measure of the market's future expectations of price movement. Implied volatility is directly derived from the market price of the option, and determined by what the market indicates (sentiment) about the stock and what it expects. The key difference is that historical volatility measures the stock's past upside and downside from a mathematical standpoint, while implied volatility defines the movements in future action. Understanding this difference in volatility is important when considering to trade options in volatile conditions.

How to Use Implied Volatility in Option Trading Strategies

The ability to know and apply implied volatility in your trading will help your trades immensely. Many traders look at IV to decide if an option is "cheap" or "expensive." A common strategy is to buy options when implied volatility is low, because they anticipate it will rise or increase resulting in a more valuable option later on. Sellers, on the other hand, like to be in a high IV environment, because they can collect more premium. The objective is to compare what the implied volatility is currently to its historical bands for the underlying asset, and it will often be a part of a much larger picture of influences affecting option prices.

Conclusion

Implied volatility typically represents a pillar of options trading, since it describes the market's estimate of a security's future price movement. Implied volatility is also a key component of an option's premium and it directly impacts the time value. After a cursory explanation, it is crucial to understand what implied volatility is and how it connects with historical volatility. When you understand what is a good implied volatility for options in relation to a particular strategy, traders have better steerage for trading options in uncertain or volatile markets. Implied volatility is a powerful tool to use, but you should always analyze it with other forms of market analysis.

Frequently Asked Questions

How can traders use IV to time their option entries?

Traders look for extremes in IV to time their entries. They may purchase when IV was historically low (because they feel it is cheap); they may sell when IV was historically high (because they feel the premiums are too high).

What happens when IV is high?

When IV is high, options premiums tend to be high because the market is expecting significant price swings. This is good, generally, for the seller, as they will receive a high premium, but bad for the buyer who will pay a higher price.

Can IV decrease after a major earnings event?

Yes, absolutely. This is a phenomenon known as "volatility crush". IV will often spike in front of an event (i.e. earnings report). Once the event passes and uncertainty is lifted, implied volatility can drop sharply, and this may drive the value of an option lower.

Is IV good or bad for options?

IV is neither good nor bad - it depends on your position. For option buyers, if IV rises, that is a positive development for the option purchase as the value is increased. For option sellers, if IV declines that is good as it may erode value.

Is IV the only factor affecting option prices?

No. While implied volatility is an important factors regarding an option pricing, there are many other factors that affect option prices, such as the price of the underlying security, the strike price of the option, the time to expiration, interest rates.