Volatility & Implied Volatility
Most forms of investing are affected by volatility to some degree, and it's something that options traders should definitely be familiar with. The basic definition of volatility in a general sense is the propensity of something to change or fluctuate dramatically. In investment terms, it relates to the rate at which the price of a financial instrument moves up or down.
A financial instrument that has a relatively stable price is said to have low volatility, while an instrument that is prone to sharp price movements, in either direction, is said to have high volatility. The volatility of financial markets as a whole can also be broadly measured; when a market is hard to predict and prices are changing rapidly and regularly, it's known as a volatile market.
Volatility in options trading is very important because it has a significant effect on the price of options. Many traders, particularly beginners, don't fully understand the implications of it and this can lead to problems. It's not impossible to make any kind of accurate forecasts about how the price of options will move without having a clear insight into volatility and the impact it has.
More specifically, without knowing the role implied, volatility plays an important role in determining the price of options. It's very difficult to be successful in options trading because of this. On this page we provide a guide to this subject, covering the following:
- What is Volatility?
- Historical/Statistical Volatility
- Implied Volatility
- Volatility Crunch
- Volatility Skew & Volatility Smile
- Profiting from Volatility
What is Volatility?
As we have mentioned above, volatility is essentially a measure of the speed and amount of changes. In a financial sense, it's basically the rate at which the price of a financial instrument moves. Before entering a trade of any kind, it's obviously useful to have an idea about how the price of the instrument, or instruments, being traded is likely to change. This is why volatility is so important to traders, as it's one of the main factors that help with forecasting what is going to happen to the price of any given security.
When it comes to options, it's a key part of how they are priced and valued and there are actually two different types that are relevant. Historical volatility, as the name suggests, is a measure of past volatility, i.e. it measures the rate of changes in price that have happened over a given period of time. Implied volatility is a projection of what the rate of change is expected to be in the future. Below, we explain more about these two different types.
Historical volatility is also commonly known as statistical volatility and often referred to simply as SV. It measures the price changes of the underlying security of options, so it is based on real and actual data.
SV basically shows the speed at which the price of the underlying security has moved; the higher the SV, the more the underlying security has moved in price during the relevant time period. Theoretically a higher SV means that that the underlying security is more likely to move significantly in the future, although it's an indication of future movements rather than a guarantee.
An important thing to note about SV is that it doesn't necessarily provide any insight into which direction an underlying security will move. A high SV may mean that the underlying security has been going up and down rapidly over a period of time, but it may not have actually moved very far from its original price. Equally, a low SV may mean that the underlying security hasn't been moving much in price, but it could be going steadily in one direction.
SV is basically used by traders to get an idea of how much the price of an underlying security will move, based on its speed of change in the past, rather than predicting an actual trend.
It can be measured over any period such as a week, a month, or a year, and there are a number of ways it can be calculated. However, when trading options you will rarely have to worry about actually calculating it yourself because there are various tools available that can do this for you. They are commonly available at most of the best online brokers.
In addition to SV, traders should also know all about implied volatility, which can also be known as projected volatility, but commonly referred to as IV. Whereas SV is a measure of the past volatility of an underlying security, IV is an estimation of the future volatility of an underlying security.
It's basically a projection of how much, and how fast, the underlying security is likely to move in price. Many traders think only of moneyness (i.e. the strike price in relation to the price of the underlying security) and the amount of time until expiration when they consider the factors that affect the value of an option, but IV also a very important factor.
IV is a variable that is used in most options pricing models, such as the Black Scholes model or the Binomial model. Given that the Black Scholes model is a highly regarded mathematical formula for calculating the fair price of options, it's clear just how relevant IV is to the price and value of options contracts.
The IV of an option is determined by taking a number of factors into account: the strike price, the price of the underlying security, the SV, the length of time until expiration, and the current interest rate. It's possible to calculate the IV that has been factored into the price option, and some online brokers provide a tool for this purpose.
As the IV of an option provides an indication of how much the underlying security might move in price, the price is typically higher when the IV is higher. This is because, in theory, there's potentially more profit to be made if the underlying security is likely to move dramatically in price. Price can often change quite substantially even when there's no move in the price of an underlying security; this is often due to the IV.
For example, if there was a lot of speculation that Company X was about to release news of an exciting new product, then the IV of options on Company X stock could be very high, as there would probably be an expectation that the price of Company X stock would move a lot when the news gets released. The news could be really well received and the stock might shoot up, or the new product could be really disappointing and the stock might drop quickly.
However, the stock price itself might not move much, as investors may be waiting for the news before buying the stock, or selling it. In such a situation, you could see the extrinsic value of both calls and puts increasing, and either could potentially be very profitable if there is indeed a big change in the price.
The options are therefore increasing in price because there is a big change expected in the price of the Company X stock, rather than any actual movement. This is basically the effect of IV in action.
If you were forecasting that the value of the underlying stock would increase dramatically once the news was released, you may decide that buying at the money calls would be the best way to take advantage of that increase. If Company X did indeed release news of a new product, and that news was well received and the stock went up significantly, then the calls option would obviously gain in intrinsic value.
The IV, though, would be probably lower because once the news had been released and the stock had moved accordingly there may no longer be an expectation of a big move in price as it has already happened. The extrinsic value of the calls could fall substantially and offset a lot of the profit made through the intrinsic value increasing.
Now imagine that you had instead decided to write in the money puts to profit from an increase in the value of Company X stock instead of buying calls. At the time of writing the in the money puts options, you would benefit from the higher extrinsic value because of the high IV. If you wrote puts with the right strike price the increase in the value of the underlying security could move them out of the money. With the extrinsic value falling due to the IV becoming lower once the announcement had been made, they would be worth significantly less than at the time of writing them.
You could then either use a buy to close order to buy them back and close your position for a profit, or wait and hope the contracts expire worthless. Either way, you have profited from both the change in the value of the underlying security and the change in the IV. Had you bought the calls, you would have profited from the change in the value of the underlying security, but the change in the IV would have reduced those profits.
This is why an understanding of IV is so important, as it can have a huge impact on the profitability of a trade. To be successful at options trading you absolutely need to recognize the potential pitfalls that IV can lead to. There are ways to profit from IV in options trading, but it isn't just as simple as buying when the IV is low and selling when the IV is high, We will come to that a little later in this article, but first there are a couple of other aspects of volatility that need explaining.
The term volatility crunch is used to describe an occurrence where a high IV drops dramatically and quickly. It typically happens to stocks following a significant event that was expected such as the release of earnings reports or important news (like in the above example). A volatility crunch can have a huge impact on the extrinsic value of options and it means a sharp decline in price.
This is why owning options with a high IV can be considered quite risky; a crunch could significantly reduce their value, even if the underlying security moves in the right direction for you.
Volatility Skew &Volatility Smile
As the effect of volatility on the price of options can be quite significant, it should be no surprise that many traders choose to analyze it before entering trades. This can be done in many ways, but one of the most common is to chart the IV across options that are based on the same underlying security but with different strike prices.
By creating a chart that shows this information, it's possible to get an idea of how the IV of specific options changes depending on their moneyness. Patterns can appear in these graphs, and there are two particular patterns that traders can look for to try and gain some useful information.
A volatility smile appears where the line that shows the IV across the different options forms a U shape, similar to a smile. When this appears, it shows that the IV is at its lowest when the options are at the money, and gets higher when they get further into the money or out of the money. This suggests that there is more demand for options that are in the money or out of the money, and less demand for those that are at the money. In turn, this suggests that large price movements are expected in the underlying security.
A volatility skew appears when the line that shows the IV across the different options is skewed to one side. It can be skewed to either side, and would mean that the IV is increasing, because the options contracts are either moving further into the money or out of the money.
Skews and smiles aren't extremely important unless you are specifically entering trades based on IV. If this is a form of trading that you are considering, then you should learn how it's possible to profit from volatility.
Profiting from Volatility
The basic principle of trading options contracts based on volatility is that you look to buy contracts that are expected to increase in IV and write contracts that are expected to fall in IV. This is a simplified take on IV, and in reality it's a little more complex than that.
Now that you have an understanding of volatility in general, you might want to think about exactly how you can put knowledge into use and profit from it. There are actually a number of strategies that can be used for this specific purpose. You can find a list of suitable strategies, with detailed information on how to use them on the following page: Options Trading Strategies for a Volatile Market.