I’ve read a few option books.
THANKS... This is probably the most comprehensive "greeks" article/book I’ve read.

Wonderful blog. …..
A wonder wealth of knowledge there. Thanks so much for your kindness in publishing it!

Thank you very much for the most concise and simplest option intro. Highly recommended.

So far, yours is the best blog/site on basic options notes in the web that I have chanced upon.

Wednesday, September 5, 2007

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).

Related Topics:
* FREE Trading Educational Videos From Trading Experts You Should Not Miss
* Option Greeks
* Learning Candlestick Charts
* Learning Charts Patterns
* Getting Started Trading

8 comments:

Tony Chai said...

Hi OTB :

Once again, an excellent article on implied volatility.

I think Option traders would be grateful if you could have future articles on other components of the options greeks :)

Just want to share, Implied Volatility (IV) is high (or even surpass historical volatility high) for a reason. A pending merger possibility, upcoming FDA announcement, earnings announcement etc. would usually inflate the IV and thus the options premium.

Thus, before an option seller gets excited selling such an option with fat premium containing high IV, it's very IMPORTANT to find out what causes such a jump in the IV by checking the latest development of the underlying stock. Then decide whether it's worth the risk to sell such an option.

Keep up the good work.

Yours Truly,

Tony Chai
http://options4u.blogspot.com

OPTIONS TRADING BEGINNER said...

Hi Tony,

Thanks for your valuable comments.
I appreciate it.

With regards to Options Greeks, I have discussed each one of its components in the following:
* Option Greeks

Feel free to give me your inputs.
I really appreciate all your comments.

Regards,
OTB

M Trader said...

Hi OTB,

Nice article you have.

I've learnt from soemwhere that the higher the IV, the higher future move it will be. Is that means it is good to buy higher IV options beside the expensive options premium? I'm a bit confuse here. Hope you can clear my doubt.

Thanks!

M Trader
http://optionstradingbeginner.blogspot.com/

OPTIONS TRADING BEGINNER said...

Hi M Trader,

To me, buying options when IV is high is still all right with the following conditions:

* Usually IV is high because we're expecting certain event that can cause the drastic price movement (e.g. earnings, FDA approval, M&A, etc.). Before that event happens, the IV usually will not drop drastically, and is also likely to rise even higher and peak on the day of the event itself.
So, if I'd like to play swing trading or day trading, I have to make sure that I close my position (sell the option) before the event take places.

* Assess the reward/risk ratio by having different scenarios of IVs, expected stock prices & time remaining to expiration (using options calculator).

* Some traders like to bet with options over such events. In this case, we have to bear in mind that some degree of price movement has been priced in with the high IV. So, when IV drops considerably right after the announcement, we can only gain if the price movement is big enough to offset the drop in IV. Otherwise, we'll lose money with options even though the stock price moves to the expected direction.

Hope this can help? :)
I'll have some posts to discuss this as well in the future.

Cheers

Anonymous said...

i just want to show my thanks for this website,very useful information ,and it helped me a lot .thanks

OPTIONS TRADING BEGINNER said...

Hi Anon,

It's my pleasure if you find this blog has helped you a lot.

Thanks for your continuous support to my blog. :)

Best Regards,
OTB

bhen-de-takke said...

Hi OTB
Firstly, thanks for the article and
If you can please explain how high IV helps option buyers ??

OPTIONS TRADING BEGINNER said...

Hi Bhen,
For options buyers, buying high IV will carry higher risk due to the possibility that the IV will drop (even worse, when it drops suddenly) as the buyers are still in the position.

However, I think it doesn't mean that we should never buy high IV options at all.
Pls see my post abt this:
What To Consider When You Are Buying An Overpriced (High IV) Options?

Hope that can help. :)

Regards,
OTB