Implied Volatility
Definition of Volatility, Implied Volatility and Historical Volatility
Volatility refers to the amount of uncertainty or risk about the size of changes in a security’s value. A higher volatility means that a security’s value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. Whereas a lower volatility would mean that a security’s value does not fluctuate dramatically, but changes in value at a steady pace over a period of time.
There are 4 types of volatility in option but I will only discuss about …
Implied Volatility
Implied Volatility is the estimated volatility of a security’s price. The implied volatility of an option contract is the volatility implied by the market price of the option based on an option-pricing model. In other words, it is the volatility that, given a particular pricing model, yields a theoretical value for the option equal to the current market price.
Historical Volatility Or Statistical Volatility
Historical Volatility or Statistical Volatility is a statistical calculation that tells option traders how rapid price movements have been over a given time frame (usually 12 months in the past).
Website that provide information on IV and HV
www.ivolatility.com.
- The chart only shows you the IV and HV according to 3mths, 6mths and 1 year.
- The chart is 1-day lag.
www.optionsxpress.com.sg.
- Go to quotes -> chart -> volatility view
- The chart will give you a comparison of the stock price, IV and HV.
- The IV chart is not up to date
Why Is Implied Volatility much more important than Historical Volatility?
This is because the HV do not affect the pricing of the option price. It is the IV that will affect the option pricing. To be precise the IV will affect the extrinsic value of the option, which are Vega, Theta and Gamma.
OTM option and ITM option have little extrinsic value and thus, are not sensitive to any changes in IV compared to an ATM option. ATM option has always the highest Vega.
How does IV affect the option price?
Assume all other factors are constant except IV.
An increase in IV will increase in the option value (call and put)
A decrease in IV will decrease in the option value (call and put)
The above statement is only truth if your option has VEGA value. An option without Vega value will not be affected by the implied volatility.
Buyer will want to buy lower IV and sell at a higher IV
Seller will want to sell at a Higher IV and buy back at a lower IV
Picture provided by ivolatility.com
From the look of the IV 3months chart of the stock Drys,
- Low is at around 59%.
- High is at around 100%
- Mid is at around 80%
At the range of 60 - 75, the option should be undervalue.
At the range of 75 - 85, the option should be fair value.
At the range of 85 - 100, the option should be overvalue.
The IV will experience a Crush after the stock is going to announce earnings, FDA approval, M&A and other important news. This is especially so for the earnings as people already price in the option value thus increasing the IV and the option price. Normally the IV will increases upon the earnings.
A great way to gain from the IV is using
Limited Risk Unlimited Gain
- When the IV is expected to RISE for the next few days
Option Strategy - Strangle and Straddle (buy call and put)
Unlimited Risk Limited Gain
- When the IV is expected to FALL for the next few days.
Option Strategy - Reverse Strangle and Straddle (Sell call and put)
Limited Risk Limited Gain
- When you want to IGNORE the IV.
Option Strategy - Bear Put/Call Spread (bearish) and Bull Put/Call Spread (bullish)
