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Tuesday, September 18, 2007

Understanding Implied Volatility (IV)

Just want to get more organized….
As you know, understanding volatility is very critical in options trading.
I’ve previously written some posts on IV & HV. I’ll put the links of all posts on this topic below, and place this on the top left corner for easier future reference.

Click the following links to read each of the posts:

1) Historical Volatility (HV) vs. Implied Volatility (IV): Definition

2) How To Get Historical Volatility (HV) vs. Implied Volatility (IV) Information:
a) How To Get HV vs. IV Info – Part 1
b) How To Get HV vs. IV Info – Part 2

3) Relationship between Historical Volatility (HV) and Implied Volatility (IV)

4) More Understanding About Implied Volatility (IV)

5) How To Determine If An Option Is Cheap (Underpriced) Or Expensive (Overpriced):
a) How To Determine If An Option Is Cheap (Underpriced) Or Expensive (Overpriced) - Part 1
b) How To Determine If An Option Is Cheap (Underpriced) Or Expensive (Overpriced) - Part 2

6) The Behavior of Implied Volatility (IV) & Historical Volatility (HV) Before & After Earnings Announcement

7) Example on How Implied Volatility (IV) Affects Option’s Price Significantly

8) What To Consider When You Are Buying An Overpriced (High IV) Options?

9) Volatility Smile and Volatility Skew:
a) Part 1: Description
b) Part 2: More Understanding
c) Part 3: Why Volatility Smile and Skew Happen
d) Part 4: Implications of Volatility Smile & Volatility Skew
e) Part5: Strike Skew and Time Skew

Related Topics:
* FREE Trading Videos from World Class Trading Experts You Should Not Miss
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Option Greeks
* Understanding Option’s Time Value
* Learning Candlestick Charts
* Learning Charts Patterns


Niladri said... a question:

Lets say there is a OTM-put and a deep-OTM-put.

Now, as option premium= Intrinsic Value + Time Value

OTM-Put premium= 0 + a

Deep-OTM-Put premium= 0 + b

As we know that because of vol-skew, deeper the OTM Put, more its implied volatility, thus more time value. Therefore, b>a.

That means, Deepet OTM Put premium > Deep OTM Put.

BUT, if we calculate the premiums through Black-Scholes Model, we get the opposite result.

Could you please explain this to me??


Hi Niladri,

Yes, deeper OTM Puts normally have higher IV than less deeper OTM Puts, and hence deeper OTM Puts are considered as "more expensive".

But that does not mean that the premium of deeper OTM Puts will be higher in terms of dollar.

This is because an option's premium is affected by 6 factors, not only IV.
Other important factors are strike price & current stock price.

Although deeper OTM Puts is higher in IV (hence it's considered "more expensive"), their option premium will be lower in terms of dollar than less deeper OTM Put options.
This because deeper OTM Puts' strike prices will be much farther from the current stock price, as compared to less deeper OTM Puts.

So, when you calculate the option's price using options calculator, deeper OTM Puts' premium would be lower in dollar than less deeper OTM Put options.

Hope that can clarify. :)
But I will also discuss this further in the next post.

Thanks & Regards,

Niladri said...


I completely appreciate and understand your point. Despite that, I would make another attempt to refute it:

As Intrinsic Value of both the OTM Puts = 0, it would then be misleading to say that:
Option Premium = Intrinsic Value + Time Value.

Instead, it should be:
Option Premium = Probability of Spot being in-the-money + Time Value??

Please excuse my mechanical approach on this topic :-)

NB: By far yours is the best blog/ site on basic options notes in the web that I fave chanced upon.

- Niladri


Hi Niladri,

It's ok. Your question actually give me "inspiration" for another topic to be discussed in the near future. :-)

The following formula is not misleading:
Option Premium = Intrinsic Value + Time Value.

Because actually Time Value here has factored in the probability of finishing ITM.

Pls see the following post:
More Understanding about Options Time Value

As mentioned above, I'll clarify this in the near future, ok? :)

Thanks for the kind words.
I'm very happy that many people in fact can benefit from this simple blog.
Thanks also for your support to my blog site. :)


Niladri said...

Thanks :)

That helped!!