Implied Volatility in Four Easy Steps

I'm taking time to write this post and hopefully enlighten your understanding of this wonderful concept. Before I get started let's define the subject for a more objective analysis.

Implied Volatility: In financial mathematics, the implied volatility of a financial instrument is the volatility implied by the market price of a derivative based on a theoretical pricing model. Or in easy terms, the expected volatility.

If I imply that the market will rise tomorrow, doesn't this mean I am expecting the market to rise? If a stock has high implied volatility, is the market expecting the stock to become increasingly volatile? The answer is yes. In the pricing of an option, volatility has a HUGE impact on how your option is priced. If volatility is high, the premium on the option will be relatively high, and vice versa.

Before we continue we need to discuss the correlation between historical and implied volatility. I shriek when someone tells me how the over/under evaluation suggests an option is over or under valued. Interestingly, the implied volatility of options rarely corresponds to the historical volatility (i.e. the volatility of a historical time series). This is because implied volatility includes future expectations of price movement, which are not reflected in historical volatility.
Implied volatility also is inaccurate due to the fact that in the US and Europe, many listed options have a market place where there is a 2-sided market with a bid (where you can sell and a marketmaker can buy) and an offer or ask (where you can buy and a marketmaker can sell). Therefore if someone buys an option on the offer the implied vol is higher for the same option than if it trades as if sold on the bid.

So thus far, we know that rising implied volatility causes options (calls and puts) to increase in value. We also know that falling implied volatility causes options (calls and puts) to decrease in value. Have you ever noticed the link on the right hand side of my blog that says "CBOE." It is there to get you implied volatility data. Click on that link, and enter your stock symbol on the left hand side. (BTW- The new toolbox will have this function on the upcoming release of the new toolbox.) When you enter your symbol, over on the right column, click on the thumbnail that says "Volatility Chart." You should see something like this...

This chart graphs two things. Implied and historical volatility. Like I mentioned earlier, there is no intelligent reason to compare the two. The future will normally always be priced higher than the past, so bet on it. What you can do here with my example on WFMI is watch that orange colored line rise and fall. This leads to the four steps I mentioned.

#1. What is the relative high that volatility reaches?

Just like finding resistance on a stock, how high does implied volatility on WFMI get? About 45-50%? This is relatively high for this stock. When I see volatility is relatively high, it means the options are relatively expensive.

#2. What is the relative low that volatility reaches?

Just like finding support on a stock, how low does implied volatility on WFMI get? About 25%? This is relatively low for this stock. When I see volatility is relatively low, it means the options are relatively cheap.

#3. Is volatility rising?

As volatility increases, for instance before an earnings announcement...the price of options gradually increase. Why? Because you are expecting the stock to move more once earnings are released. Do you think that the chart above is magical the way it peaks about every three months???

#4. Is volatility falling?

As volatility decreases the price of the options will lose their value. Of course, not intrinsic value...their time value will get smaller. IMPORTANT: Volatility only impacts the time value of your option. If you trade ATM or OTM options, these will be heavily influenced by volatility.

In closing, I hope your understanding is that ideally you want to buy options when volatility is low and starting to rise. Or if volatility is high and starting to fall, you want to sell. Also remember that when volatility is high, you might want to see why expectations are high. Perhaps earnings, judgments, FDA approvals, etc. Listen to my class on Monday mornings to go over various examples, or run over to the black scholes calculator and start inputting parameters. Change volatility numbers based on relative highs and lows.

Last comment and I am going home. How many times did I use the word "relative?" Every stocks volatility is different. For example, WFMI was as high as 50%...that might be another stocks low. Every issue is different. Remember it's not the value, but where the value has been, and where it is going.

I kick major ass for writing this tonight(patting myself on the back). See you tomorrow.


Absolutely, without question, the most valuable piece of information on your blog thusfar. This will answer the question that myself and i'm sure MANY other new traders ask, which is: "If I guessed the right move, why am i DOWN money on my options?"

Thanks, Jeff. This was fantastic!

I once was blind but now I see! The lights just came on! Thank you, thank you, thank you!!!

You in just a few short paragraphs explained what most "experts" try to do in chapters.

Awesome work!!!Be proud Jedi Knight!!!

Randy

Thanks for taking the time to blog as you do. I'm still fairly new to investing/trading and find this highly informative. I regret my wife and I didn't get to meet you when we were in Utah for LT. When your blogging schedule allows could you cover creating or building rules? I find this has been the hardest part for me in defining how best suites my developing trading style. Some example rules would be helpful. Hopefully others will add to the blog as well.

Jeff, this is great stuff! Thank you very much. One disadvantage I have is that I'm in the Masters Program, so I can't see your presentations. I can't tell you how much I appreciate the information you present here. I kept hearing and reading about volatility, but didn't understand it, until now! thanks again.

If this post isn't worth the price of admission!!! Sometimes you read stuff like this and get the "aha" moment. As a learner of the markets and I was always wondering about the over/under calc on the toolbox. One of the live events on advanced options, Stacy Acevedo mentioned about selling highly volatile options...I wondered why we would be instructed to buy low volatile options since this in essence would indicate there was no belief the option was going to move. Anyway, in the quest to sort this stuff out, it helps see it a bit clearer.

Kudos to guru Jeff...

Great presentation last night.

Travis Roy
travis.roy@insightbb.com

Jeff

Just awesome info. Please don't hold back!

All I can say Jeff is you are right, you did kick ass on that one. You are always full of surprises!

Pat on the back

Deltatrader.

Seriously great blog about IV, one of the chosen few who understand.

Golf Saturday?

This is mostly directed to Travis the gentleman who posted before my last comment.

IV is driven by supply/demand for options on that stock or index and SPECULATORS are the folks doing the driving in equity options. Speculators are usually wrong. If implied volatility is high, speculators are speculating in excess through buying options that the stock will make a large move. The contrairian in me will normally take that high volatility condition as a great time to assume those speculators are WRONG and not buy the options market. I love taking the opposite side of speculators, BECAUSE SPECULATORS USUALLY ARE WRONG and the stock probably won't make the expected grandiose move. Happens on earnings almost everytime.

On the other hand, when the IV is low, speculators are not buying options. Knowing speculators are usually wrong this provides an outstanding time to buy options. They are cheap and the stock will likely make your forecasted move.
That is right where you want to be as an option buyer.


Deltatrader

Great post!

Just to make sure I understand this.....

If you have a stock with high volatility, relative to itself, and is declining - this might be a good opportunity for a credit spread.

If you have a stock with low volatility, and is increasing - this might be a good opportunity for a call, put, or a back spread.

Thanks for all that you do Jeff.

Randall

Thanks Jeff,
This was an absolutely great post!!

I am also a Master's student and feel that the basic options course leaves a great deal to be desired!

I appreciate any further options posts that you make for I definately feel that picking the right option is where I lack the most.

I am considering signing up for advanced options trading room just to get into your new class.

Thanks for blogging and keeping me motivated!!

Rene Lee

Jeff,

Your Article caused me to go in search of additional information about Volatility and it's impact on Option Prices. I found a couple of good "nuggets" that helped me to build upon what you provided.

1. Volatility changes have an impact on Options Prices:
-ATM will have the largest nominal change
-OTM will have the largest percentage change
-ITM will have the smallest nominal percentage change

Exp: QQQQQ @ 37.98 with an implied volatility of 16.5%. Raise the volatilty to 32% (extreme increase but to show the effects of increased volatility).

ITM - Apr 35 Call $3.30-$3.40 becomes $3.80

ATM - Apr 38 Call $1.05-$1.10 becomes $2.00

OTM - Apr 41 Call $0.10-$0.15 becomes $0.90

As you can see the OTM's are affected the greatest with an increase in volatility.

Hope this helps add to the original article? It did for me.

Randy

Two other traits about volatility that seem pertinent are: volatility is mean reverting and it tends to have strong autocorrelation.

In plain English, unlike the movement of price, once volatility moves far away from its mean or average, it will move back towards its average. The autocorrelation part of the equation is that once volatility does move in a direction, it will have a tendency to keep moving in that direction. Once the volatility gets to its relative high or relative low and reverses, look for it to move back to its average.


Jeff H. Wash DC

hi,

first of all congrats for your best business blog awards.

Do you have a good trading system ? would you mind sharing it ?

thanks

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