More Understanding About Implied Volatility (IV)

In options trading, it’s crucial that one must understand the impact of volatility on options pricing. Because it’s possible that the stock price has moved profitably, but the option’s price did not.

Options Pricing & Implied Volatility (IV)
In options pricing, it is the Implied Volatility (IV) that affects the price of an option, not Historical Volatility (HV).
IV has a huge impact on the option price. However, it is important to highlight that IV affects only the time value component of an option's price, not on the Intrinsic Value. Therefore, ATM (At-The-Money) and OTM (Out-of-The-Money) options are the ones that will be greatly affected by IV movement, as compared to ITM (In-The-Money) options. How much IV changes affect an option’s price can be estimated from its Vega.
To get data on Vega, as well as other options greeks (Delta, Gamma, Rho, Theta) for various strike prices and expiration months, we’ve discussed it before here.

How does IV influence an option’s price?
Assuming all factors remain constant:
An increase in IV will increase an option’s price (both Call and Put options).
A decrease in IV will decrease an option’s price (both Call and Put options).

The reason is because higher IV implies that a greater fluctuation in the future stock price is expected due to some reasons. And with greater expected fluctuations, there will higher chances for an option to move into your favor by expiration.
Therefore, when volatility is expected to be high (i.e. higher IV), option’s prices will relatively be more expensive.

The Effect of IV on Option’s Buyer and Seller
As higher IV causes option price to rise (assuming other things constant), an increase in IV would benefit option buyers, but will be disadvantageous for option sellers (for both Calls & Puts).
On the other hand, a decrease in IV would have a negative impact on option buyers, but will be beneficial for option sellers.

As a result:
When IV is relatively low and is expected to rise, buy options (i.e. consider options strategies to take advantage of the expected move that allow us to be an option buyer).

When IV is relatively high and is expected to drop, sell options (i.e. consider options strategies to take advantage of the expected move that allow us to be an option seller).

Implied Volatility (IV) For Various Strike Prices
IV is generally not the same for various strike prices, and also between Call & Put options.
For the same expiration month, IVs vary by strike prices.
For some options, the IV of ITM & OTM options are higher ATM options. Hence, when the IVs for various strike prices are plotted into a chart, it would take shape approximately like a U-pattern, which is by glance, it looks like a smile. As such, this is often known as “Volatility Smile”.
Other options may have higher IV for more ITM options and then it’s decreasing as it moves towards OTM, or vice versa. Such pattern is called “Volatility Skew”.
Basically, either Volatility Smile or Volatility Skew is typically used to describe the general phenomena that IVs vary by strike price.



Picture courtesy of: riskglossary.com/link/volatility_skew.htm

To understand more about Implied Volatility, go to: Understanding Implied Volatility (IV).

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