Definition of Implied Volatility
Implied Volatility (IV) means refers to the probability with respect to the expected change in the price of stocks or options contracts or any other publicly traded financial instrument, which is captured by analyzing the movement in the price of said securities and which helps the investors to understand the expected future change in their value of investments.
Explanation
- IV is an estimation made by the market regarding the prices that may change in the future. Thus, it is a forecast made by market sentiments.
- One should note that IV is different than historical volatility or statistical volatility. Statistical volatility measures the price change using past data.
- Options contracts are measured using IV. Here, the major pillars for computing implied volatility are supply, demand, and time value.
- It is expressed in percentage terms. This percentage is applied to the stock price to compute the expected volatility. σ (sigma) is the symbol used to denote this percentage.
- If IV increases, the supplementary option premium also increases. The impact is higher in the case bearish market & impact is lower in the case bullish market. This is the reason why when the market falls, it falls speedily and when it rises, it increases steadily.
- The IV can be better understood with the following chart/diagram. Please note that the source website can also help you directly calcite the option by providing a certain set of inputs
Image Source: https://www.samco.in/knowledge-center/articles/what-is-implied-volatility-or-option-iv/
Example of Implied Volatility
Investors to invest in a stock that has the following attributes. However, he is confused about the movement in price. He has provided his expectations about the price.
Lowest Price in the year | $ 95 |
Highest Price in the year | $ 255 |
Current Market Price (CMP) | $ 160 |
Implied Volatility | 15% |
Probability of up-move | 50% |
Probability of down-move | 20% |
Probability of highest price | 20% |
Probability of lowest price | 10% |
Solution:
Particulars | Expected Price (x) | Probability (y) | Value ($) |
Upward move | 184 | 50% | 92.00 |
Downward move | 136 | 20% | 27.20 |
Highest Price | 255 | 20% | 51.00 |
Lowest Price | 95 | 10% | 9.50 |
Total | 179.70 | ||
Return | 12.31% |
Explanation
- With the probabilities provided by the investor, the price tends to move in an upward direction. However, the conclusion is derived using the probabilities. Thus, IV only helps to quantify the quantum of change (i.e. $ 184 or $ 136) from the current market price.
- Thus, the investor should understand the actual movement in the price can be different than the same depicted above.
Implied Volatility and Option Prices
- The price of an option is majorly dependent on the IV as relevant for the contract. When you buy an option contract, you are given the right to buy/sell the underlying asset at a predetermined price within the option period. In case of higher implied volatility, the prices will be higher in the future. Thus, the price of the option contract will also be higher today. The opposite is the case when the implied volatility is lower.
- Thus, when we buy an option, the difference between buying & sell is the profit. One should note that IV is an uncertain estimation of the future price & not a guarantee of the movement.
- The actual price in the future is not responsible to follow the predicted IV. The actual prices majorly depend on the demand & supply functions prevailing at those times. Implied volatility only helps to estimate the expected change and the direction of such change.
Implied Volatility Chart
CBOE (Chicago Board Options Exchange) is the Volatility Index (VIX) for S&P 500 index. The implied volatility can be depicted using the following chart:
Image Source: https://in.investing.com/indices/volatility-s-p-500-chart
Factors that Affect Implied Volatility
- The supply & demand of assets are the major factors that affect the IV, which in turn changes the price of the options contracts that underlie such assets.
- The reason lies in basic economic principles. As the demand rises, the price of the product rises. Thus, higher implied volatility depicts a higher premium for the options contracts.
- The opposite is the case with lower demand. In case of lower demand, the price offered by market sentiments is lower. Thus, a lower IV depicts a reducing option premium. Similarly, we can say that in the case of higher supply for reducing demand, the implied volatility is ought to fall. Thus, the option price is cheaper.
- Along with demand & supply, the time value of money is another factor that impacts the volatility figures. The shorter the duration of the option contract, the lower the option premium & thus, the lower the implied volatility. The longer the duration of the option contract, the higher the option premium & thus, the higher the implied volatility. The reason is simple. The amount of time affects the value of the option premium.
Implied Volatility Indicator
- The most widely used indicators for implied volatility are CBOE VIX (i.e. Chicago Board Options Exchange Volatility Index), Bollinger Bands, and ATR (i.e. Average True Range).
- CBOE VIX is known by its symbol (i.e. VIX). VIX is nothing but value derived from option prices. This reflects the implied volatility in the market. Derivatives are actively traded here. In case VIX has a value greater than 30, it indicates higher volatility in the market. Presently, the CBOE VOX is approximately 25 as of September 30, 2020.
- Bollinger bands are two lines of standard deviations for 20 days moving average prices. These lines are placed below & above 20 days moving the average price of a stock. If these bands widen, it shows an increasing quantum of volatility. Thus, the widening of bands is related to an increase in prices. Conversely, compressing these bands is correlated with decreasing volatility.
- Average True Range (ATR) is used for any stock, futures contract, forex instruments, or ETFs. It is a 14 days exponential moving average. It uses three equations to compute the ATR. In case the ATR is larger, it indicates an increased quantum of volatility.
Why is it Important?
- It is important for the investor to predict the expected change in the price, which will help him to take better positions to tackle any prospective loss.
- Lower volatility represents lower changes in price expectations.
- It is important for the calculation of option prices.
- It does not copy the movement of option prices as per the historical volatility index. Thus, implied volatility has different importance than historical volatility.
Advantages of Implied Volatility
Some of the advantages are given below:
- It helps the investor to make a strategy for his portfolio that will behave in accordance with implied volatility.
- It helps traders to make short-term gains with the help of predictions.
- It considers market sentiments, which are difficult to guess for a layman.
- It helps to channel the price of options contracts. Thus, it provides a valuation basis.
- Traders or investors can take trading decisions on the basis of these figures.
- The uncertainty element of the market is captured in figures.
Disadvantages of Implied Volatility
- It depends on market sentiments, which may change at any time. Thus, investors should not completely rely on this indicator.
- The investors have suffered the risk of incurring losses and depend completely on VIX.
- It is based only on time value, and supply & demand functions and thus it does not take into account the fundamentals of the stock. Fundamentals reflect the true worth of the stock.
- It only defined the quantum of movement & not the direction.
Conclusion
Implied Volatility is a measure of fluctuation in the value of options contracts or the expected change in the price of the security. The impact of implied volatility is higher in a bearish market since the word falls downs quickly on negative hopes. The weight of negativity is higher in today’s economic environment. Similarly, the impact is lower in the case of bullish markets. Time Value, demand & supply are the main pillars of implied volatility. Largely, it helps in deciding the price of the options contract.
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