Understanding Implied Volatility
Implied Volatility | Volatility Rank
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Bullish Option | Diagonal Spread
Understanding Implied Volatility
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Implied volatility (commonly referred to as volatility or IV) is one of the most important metrics to understand and be aware of when trading options.
In simple terms, IV is determined by the current price of option contracts on a particular stock or future. It is represented as a percentage that indicates the annualized expected one standard deviation range for the stock based on the option prices. For example, an IV of 25% on a $200 stock would represent a one standard deviation range of $50 over the next year.
The implied volatility of an option is the theoretical volatility based on the option’s quoted price. The implied volatility of a stock is an estimate of how its price may change going forward. In other words, implied volatility is the estimated volatility of a stock that is implied by the prices of the options on that stock. Key points to remember:
The expected move can be calculated by adding the ATM call and the ATM put. This is also how the options creators define a one standard deviation move.
ATM call + ATM put = expected move = 1 SD move
What is Implied Volatility?
Implied volatility is derived using a theoretical pricing model and solving for volatility.
Since volatility is the only component of the pricing model that is estimated (based on historical volatility), it’s possible to calculate the current volatility estimate the options market maker is using.
Higher-than-normal implied volatilities are usually more favorable for options sellers, while lower-than-normal implied volatilities are more favorable for option buyers because volatility often reverts back to its mean over time.
To an options trader, solving for implied volatility is generally more useful than calculating the theoretical price, since it’s difficult for most traders to estimate future volatility.
Implied volatility is usually not consistent for all options of a particular security or index and will generally be lowest for at-the-money and near-the-money options.
Since it’s difficult on your own to estimate how volatile a stock really is, you can watch the implied volatility to know what volatility assumption the market makers are using in determining their quoted bid and ask prices.
What does “one standard deviation” mean?
In statistics, one standard deviation is a measurement that encompasses approximately 68.2% of outcomes. When it comes to IV, one standard deviation means that there is approximately a 68% probability of a stock settling within the expected range as determined by option prices. In the example of a $200 stock with an IV of 25%, it would mean that there is an implied 68% probability that the stock is between $150 and $250 in one year.
Why is this important?
Options are insurance contracts, and when the future of an asset becomes more uncertain, there is more demand for insurance on that asset. When applied to stocks, this means that a stock’s options will become more expensive as market participants become more uncertain about that stock’s performance in the future.
When the uncertainty related to a stock increases and the option prices are traded to higher prices, IV will increase. This is sometimes referred to as an “IV expansion.”
On the opposite side of IV expansion is “IV contraction.” This occurs when the fear and uncertainty related to a stock diminishes. As this happens, the stock’s options decrease in price which results in a decrease in IV.
In summary, IV is a standardized way to measure the prices of options from stock to stock without having to analyze the actual prices of the options.
What is Volatility Percentile?
IV Percentile weighs each day equally. In the IV Rank example, that earnings spike to 200% has a much heavier weight than the other days of normal IV, because it single handedly moved the range by 50%.
- IV percentile takes all the trading days for the past year, and measures the percentage of days IV was lower than the current level.
- This means that even if there was a spike in IV for one day, it wouldn’t change the calculation as drastically. That one data point would then just be excluded from the percentage of days IV was below the current level.
- This results in a much smoother calculation, but it is harder to calculate off hand than IV Rank.
In any case, putting context around IV is important regardless of whether you use IV Rank or IV Percentile.
- Pick one that you’re comfortable with and sticking with it
What is Volatility Rank?
- IV Rank is a measurement from 0 to 100 that analyzes the high IV point & the low IV point over a certain time frame, and weighs current IV levels against those points.
- Look at a time frame of one year.
- For example, if an underlying had an IV low of 50% and an IV high of 150%, an IV rank of 50 would mean IV was currently at 100%.
- If that same underlying had an IV of 50% or lower, it would have an IV Rank of 0. If it had an IV of 150% or higher, it would have an IV Rank of 100.
- One of the concerns with IV Rank is that it doesn’t take outlier IV spikes or lulls into account.
- If an earnings announcement spikes IV to 200% just for one day, the new measurement for IV Rank would be from 50% to 200% for that same underlying.
- IV Percentile looks to smooth out this flaw and provide a more accurate reading.