What is implied volatility in options trading?
Implied volatility (IV) is crucial in options trading, affecting pricing and strategy selection. This guide explores how IV influences options, helping you make more informed decisions.
What is implied volatility and what does it show?
Implied volatility is the market’s forecast of potential price movements for an underlying asset. Expressed as a percentage, it indicates the expected magnitude of price changes, typically over a year. You can use IV to assess options pricing, risk and trading opportunities.
Key points to remember about implied volatility:
- It’s derived from options prices
- It reflects market sentiment about future volatility
- It doesn’t predict price direction, only the potential magnitude of price changes
- High IV suggests significant expected price swings
- Low IV indicates expectations of more stable prices
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Example of implied volatility
Let’s consider an example using the SPDR S&P 500 ETF Trust (SPY). Suppose SPY’s current market price is $423, and we’re looking at two different expiration periods:
- 64-day expiration: the IV is 19.1%, implying a potential move of more or less $18.80. This suggests a range of between $404.20 and $441.80 over the next 64 days
- 365-day expiration: the IV increases to 23.7%, implying a larger potential move of about $59.30. This projects a wider range of between $363.70 and $482.30 over the course of a year
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How implied volatility works in equity options trading
Implied volatility is a critical component in options pricing models and trading strategies. It's calculated using complex mathematical formulas and helps determine the expected move (EM) of a stock over a given expiration cycle.
We use the EM formula to calculate the one standard deviation (SD) range of a stock, where:
EM = 1 SD expected move
S = stock price
IV = implied volatility of your option's expiration cycle
DTE = days to expiration of your options contract
This formula enables you to calculate potential price ranges based on current market conditions. It’s important to understand the probabilities associated with standard deviations:
- One standard deviation (1 SD) encompasses approximately 68.2% of outcomes
- Two standard deviations (2 SD) encompass approximately 95.4% of outcomes
- Three standard deviations (3 SD) encompass approximately 99.7% of outcomes
This means that most price movements (about 68.2%) are expected to fall within the 1 SD range. Larger moves become progressively less likely, with 3 SD moves being rare occurrences often referred to as ‘black swan’ events.
IV levels also provide insights into market sentiment. Low IV suggests the market expects relatively small price movements and high IV indicates expectations of larger price swings. It's worth noting that IV tends to increase in bearish markets and decrease in bullish markets, reflecting changing risk perceptions among traders.
However, volatility can increase on individual names that experience sharp up moves, hence the meme stock craze.
How implied volatility impacts options
Implied volatility significantly affects options pricing and strategy selection. Here are some of the key ways IV influences options:
- Options pricing: IV is a crucial factor in determining option premiums. Higher IV leads to higher options prices, as there’s a greater chance the option might move in the money
- Extrinsic value: IV has a direct relationship with the extrinsic value of options. Higher IV environments result in more expensive options due to increased uncertainty, which can impact an option’s extrinsic value
- Strategy selection: you may want to adapt your strategies based on IV levels. For instance, options selling strategies may be more attractive in high IV environments due to higher premiums
- Risk assessment: IV helps traders gauge potential risks and rewards. High IV implies larger expected moves, which can affect position sizing and risk management decisions
- Binary events: IV is particularly useful when analysing binary events, such as earnings or economic events, to determine the market's expectations regarding the underlying's reaction post-event
- Volatility trading: if you focus on trading volatility itself, IV might be one of the key metrics to use in your decision making
Options pricing models explained
Options pricing relies on sophisticated mathematical models. While you don't need to master the models themselves, understanding the basics behind them can provide valuable insights. Let's explore two key models:
Black-Scholes model
The Black-Scholes model is the primary method for deriving implied volatility. It quickly calculates options prices based on several inputs:
- Stock price
- Strike price
- Time to expiration (as a percentage of a year)
- Risk-free interest rate
- Dividends
- Implied volatility (the only unobserved variable)
Importantly, changes in options prices drive changes in IV, not the other way around. Most trading platforms provide IV% values and expected move calculations based on this model.
Binomial model
The binomial model offers a more intuitive approach to real-time pricing. It uses a decision-tree framework to model prices in a stepwise fashion. The model considers two possible outcomes at each step – a move up or a move down.
This approach allows for more flexibility in modelling complex options scenarios, particularly for American-style options that can be exercised before expiration.
Implied volatility vs realised volatility
Understanding the relationship between implied and realised volatility is crucial for making informed trading decisions.
Implied volatility
Implied volatility represents the market's current expectation of future volatility. It's derived from options prices and reflects the market’s view on potential price movements over a specific period.
Realised volatility
Realised volatility measures the actual price movements that have occurred over a past period. It’s calculated using historical price data.
Interestingly, historical data shows that IV tends to overstate actual realised volatility. This overestimation of future volatility can create opportunities for options sellers, as the fear of uncertainty often leads to inflated options prices.
How to use implied volatility
To use implied volatility when trading options, follow these steps:
- Determine whether implied volatility is high or low
- Research why some options yield higher premiums
- Identify options with high IV that could be a premium selling opportunity
- Identify options with low IV that could be a premium buying opportunity
Determine whether implied volatility is high or low
You can establish this through an option’s IV rank or IV percentile. The formulas for calculating both are shown below.
IV rank (IVR)
IV rank is a percentile measure of an option's current IV compared to its historical IV range. A high IV rank
(eg 90%) indicates the current IV is near its highest levels, while a low IV rank suggests the IV is relatively low compared to its past.
IV percentile
IV percentile measures the percentage of days over a specific time period where the implied volatility was lower than the current IV. For example, an IV percentile of 75% means that the current IV is higher than 75% of the observed IV values in the given time frame.
This information can help you:
- Determine if options are relatively cheap or expensive
- Define entry and exit conditions for trades
- Identify opportunities to buy undervalued options or sell overvalued ones
- Improve breakevens by selling premium in high IV environments
Note that neither measure is better than the other; they simply provide more context about implied volatility. Remember that IV tends to move in cycles and often reverts to its mean, especially after reaching extreme highs or lows.
Research why some options yield higher premiums
High IV often results from significant events like upcoming earnings announcements. You can research factors that influence volatility – and consequently options premiums – using tools like our in-platform video feed and market watchlists.
Identify options with high IV that could be a premium selling opportunity
In high IV environments, many traders use options selling strategies such as credit spreads, naked puts, short straddles/strangles and covered calls. These strategies can potentially improve your breakeven points compared to selling premium in low IV environments.
High implied volatility example
Let’s compare selling a put at the 95 strike in high and low IV environments with XYZ stock trading at $100.
High IV: the put might be worth $7, offering a maximum profit of $700 if it expires out of the money (OTM). If it goes in the money, the $7 premium reduces your breakeven to $88.
Low IV: the same put might only be worth $3.50, halving both your maximum profit and breakeven reduction.
This example illustrates how high IV can significantly impact trade entry prices and strike price proximity.
Identify options with low IV that could be a premium buying opportunity
In low IV environments, you might consider options buying strategies such as debit spreads, naked long puts/calls and diagonal and calendar spreads.
Low implied volatility example
Compare collecting $3.50 in premium by selling puts in high and low IV environments:
High IV: you might sell the $90 strike put for $3.50, with a breakeven of $86.50, if assigned shares.
Low IV: you’d need to sell the $95 strike put for the same $3.50 premium, resulting in a higher
breakeven of $91.50.
This example shows how IV affects the strike prices you can choose for a given premium.
Implied volatility example
Consider a stock trading at $100 with 20% implied volatility. Over 12 months (one standard deviation), there’s a 68% chance the stock will trade between $80 and $120. There’s a 16% chance it will be above $120 or below $80.
This concept is crucial for probability-based traders. For instance, when setting up a strangle or iron condor, combining an 84% OTM short call with an 84% OTM short put gives you about a 68% probability of success.
If a stock is trading at $50 with 20% IV, for example, the market consensus suggests a one standard deviation move over the next 12 months will be plus or minus $10 (20% of $50).
FAQs
What is a high implied volatility for options?
The concept of ‘high’ implied volatility (IV) is relative and depends on both the specific product and the trader’s perspective. Exchange-traded funds (ETFs) typically have lower IV compared to individual stocks as they consist of a basket of stocks, as equities face more potential for significant moves due to events like earnings announcements.
To determine if IV is high or low for a particular asset, traders use contextual metrics such as IV rank or IV percentile. These tools compare current IV to its historical range over the past year, providing a clearer picture of whether current volatility is elevated or subdued relative to recent history.
For options buyers using debit spreads, high IV environments mean more expensive options. Conversely, options sellers using credit spreads may find high IV attractive due to the higher premiums available.
What is a low implied volatility?
IV of around 20-30% is typically considered low. However, it’s crucial to understand that even in low IV environments, there’s still a 16% chance that the stock price could move beyond the implied range over the course of a year. It’s important to note that assets with low implied volatility and a high probability of profitability don’t guarantee a successful trade.
Low IV doesn’t necessarily mean low risk or lack of movement. It simply indicates that the market expects relatively smaller price fluctuations compared to periods of higher IV. Traders should always consider other factors alongside IV when assessing potential trades.
How does implied volatility affect options prices?
Implied volatility and options prices have a symbiotic relationship:
- Higher IV leads to higher options prices, as it suggests a greater likelihood of significant price movements in the underlying asset
- In high IV environments, options sellers can collect more premium or choose strikes further from the current stock price while still receiving substantial premiums. However, it’s important to note that the market is reflecting greater uncertainty with higher premiums
- Low IV environments allow traders to speculate on directional moves with long options strategies at a lower cost due to reduced extrinsic value across all strikes. But, when selling premium in a low IV environment, it’s important to consider that extreme moves are still possible
- Traders often adjust their strategies based on IV levels. For instance, they might favour premium-selling strategies in high IV environments and premium-buying strategies in low IV environments
- IV helps traders gauge potential risks and rewards, influencing decisions on position sizing and risk management
- Many short premium traders look for extremes in IV, anticipating a potential reversion to more normal levels, which can create trading opportunities
Remember that while IV is derived from options prices, changes in options prices lead to changes in IV, not the other way around. This relationship is crucial for understanding how market dynamics affect both IV and options pricing.
The content on this page relates specifically to listed options, which can be traded using our US options and futures account.
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