The underlying security or index in an option swings up and down with significant movement sometimes in a day, making the price of the option highly volatile. The reason behind the volatility could be anything from market conditions to stock-specific news, corporate actions or the demand and supply of the underlying security in the market.
This volatility factor also affects the price of option premiums in the derivatives market. Hence understanding and measuring the volatility is very important to utilize the advantages and disadvantages of this factor into option trading. Implied volatility is the tool that will help you measure the fluctuation level and how to use it in options trading.
What is Implied Volatility in Options?
Implied Volatility (IV) measures the level of expected volatility in the price of an underlying security. When Implied Volatility is high, the price of the underlying security moves swiftly upside and downside, and when IV is low, the fluctuation in the price of the underlying security moves slowly.
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When the IV of an underlying security is high, the premium of the option contract which is simple term known to be price also fluctuates as per the movement in IV. A high implied volatility is good for the option buyer and bad for the option sellers.
How is IV Different from Historical Volatility?
Implied volatility is used to calculate and express the expected future volatility of the underlying security, while historical volatility is calculated by taking the high and low values that are generally based on the change from one closing price of past trading sessions of an underlying security.
However, the historical volatility of an underlying security can tell you the nature of volatility levels in previous trading sessions in various market conditions. But it can't give you the true picture of future volatility, or how prices will fluctuate in future. Hence, implied volatility works better to know the probability and trading range of an underlying security.
Option Price and Implied Volatility
In option pricing, implied volatility plays an important role in giving the probability of risk due to instability in the price of the underlying security.It shows you the future expected price that an option can oscillate, which is reflected in the premium of the option.
The higher the implied volatility, the higher the premium and the lower the IV means the premium of the option will also be low. The IV does not show the exact price movement in a single direction, instead, it shows the probability or the range, between that price will move. There is no guarantee, that the price will move in the same pattern but you can expect it.
The option price is directly correlated with implied volatility, hence the increase in IV also leads to a high option price and a low IV means the option price will be also lower. Hence, while placing the order in option trading check the IV and if you are an option buyer and the IV increases it is good for you but bad for the option sellers.
How to Read Implied Volatility Options?
Reading the implied volatility is very simple, as it is represented in terms of percentage (%) which means the price of an option can change that much percentage. If the implied volatility is 25%, it means the price can move up or down during the trading.
Usually, the IV is calculated and expressed as an annualized percentage, which means as per the IV the underlying security price or option price can move up or down over the course of the year. However, for daily and weekly implied volatility, you can convert the annual IV using the standard deviation formula for different periods as per your needs.
Importance of Implied Volatility in Options Trading
For option traders, considering the implied volatility while taking decision in regards to any security or indices is important as it affects the price of the option premium. As implied volatility rises the premium of the option also rises. Hence, while entering into the option contract always check the latest IV of the underlying.
If you are an option seller, high IV can benefit you in terms of pushing the option premium at high levels before the expiry. If you are an option buyer, pick the underlying security having a low IV, as it will be available at a low premium. However, when the premium settles around the same levels or might become worthless before the expiry, it is beneficial for option sellers.
Also Read: Why Option Selling is Better than Option Buying: Explained
How to Use Implied Volatility in Options Trading?
The IV helps to gauge the estimated potential range of the movement in the underlying security. Hence you can use the IV to select the best stocks for option trading having the IV as per your trading strategy. To use the IV in the option trading you have to find out the IV of the underlying security and then decide whether to buy or sell the option.
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If the IV is high, there could be multiple reasons like major news events to be announced, corporate earnings announcements, mergers or acquisitions new product launches or unexpected volume growth in the product sales and services. Owing to such factors the demand and supply of the underlying security also leads to high IV in the option.
Long Option if Low IV: If you looking to buy an option contract, then find out the underlying security having the low IV. The first thing the low IV option will be trading at a low premium price and due to low IV the option premium price will be also not affected too much. Here you need to trade in long calls with the right option trading strategy works for low IV.
Short Option if High IV: While on the other hand if you are looking to make profits from option selling, then choose the underlying security trading with high IV. When IV is high you will get the advantage of selling the option at a higher price, as during high IV the option price also trades at a high price. And when the expiry option settles around the zero levels you will earn the profit.
High IV and low IV both have their own advantages and disadvantages, you can choose the right underlying security as per your trading strategy and the current market conditions. But the question here is how much-implied volatility is good for the options.
What is a Good Implied Volatility for Options?
The level of good IV depends on the types of underlying assets, IV for underlying index trading on exchange would be higher compared to IV for individual stocks. However, an IV between 20% to 25% is considered good for the options, but still choosing the right IV also depends on the option premium price, days left in the expiry and the trading strategy.
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For option selling you can consider high IV good while for buying the option, the low IV is better. Apart from that the position of the strike price from the spot price in options is also very important while deciding the IV levels in the option trading. However, in extreme market conditions, the IV can go beyond 40% making your trade position very risky. Hence, as per the IV you have to pick the right stock and also choose the best option trading strategy.
Implied Volatility Options Trading Strategies
For options traders, the best way to maximize your chance of getting positive returns over long run is to always trade in the direction of the trend with right strategy. There are various option trading strategies you can choose as per the market condition and IV of the underlying security.
Option Trading Strategies as per the IV:
Long Straddle: long straddle strategy is initiated when there is a big event due in near term like union budget, and the probability of better or worst are equal. During such times the implied volatility or we can say risk of market going in either side increases. This is one of the very popular option trading strategies for such times. In this strategy, a trader has to buy a call option and put an option of the same underlying security with the same strike price and expiration date. It is a neutral strategy, that can give you profit when there is significant movement in either direction.
Long Strangle: This options strategy can be also useful but when IV is low and significant movement in the market is expected due to any influencing news outcomes. Under this strategy, you have to buy a call with a higher strike price and put the option of a lower strike price of an underlying security.If due to high IV, the price moves in either direction, then you will earn profit from an increase in option value.
Short Straddle: this option strategy is implemented when the implied volatility is high; meaning a big even is due in near term. But trader’s instincts say that the underlying will not show sharp movement in either side meaning that the underlying will trade in a range when the event is over and premium prices will cool down. Under such scenario, a trader can implement short straddle strategy and earn from higher premium prices given that the underlying trade in a range. For implementing this strategy, the trader sells a call and put an option of the same strike price and expiration date of an underlying security.
Also Read: How to Choose or Pick the Right Strike Price in Option Trading
Short Strangle: This strategy will work when a trader expects slow movement in underlying but not a very sharp moment in either side. The trader while implanting this strategy looks to capitalize on time decay of option premium with minimal price movement in a underlying with drop in volatility, or a combination of all three. For implementing this strategy, one has to sell a call and put option strikes equidistance from the spot price of the same expiration date. If the price remain between the short option strikes the trader stand to gain as both the option contract will expire worthless. If the prices move sharply in either direction the trader will see losses on directional option.
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Long Iron Condor: Under this option strategy you have to buy a call and put an option of the same strike price and also sell a call with a higher strike price and put of lower strike price with the same expiration date. This mix of buying and selling of call and put can increase the cost of your option strategy but the wings of both sides will protect you against significant moves in either direction.
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Short Iron Condor: This option strategy also can be beneficial for traders when the IV is neither too low nor too high. The trader expects underlying to trade in a range and wants to benefit from same scenario. While undertaking his theory, he wants to be protected in case underlying sees sharp movement. So he sell an OTM call option and put option and then buy even higher strike OTM call and even lower OTM put option. The entire options contract has same expiration date, and it will be profitable for you when the option price trades sideways.
Also Read: Best Option Strategies for Sideways or Range Bound Market
Volatility Arbitrage: Under volatility arbitrage strategy, a trader buys and sells options contracts to earn profits from the high-low implied volatility difference. A trader can buy a high IV option and sell a low IV option with the expectation of earning a profit from the option price difference.
Final Thoughts
Trading inhighly volatile market conditions could be very risky, especially for beginners or inexperienced traders who don't have too much idea about trading in the future and option market. Implied volatility for the index or any individual underlying security will let you know how far high and low the price can go during the upcoming trading sessions.
Also Read: How to Trade in High Volatile Market: Best Trading Strategies
Based on the level of IV, you can choose the right stocks for trading in the options market. As per the range of IV, you can decide to go for long or sell the options or enter into the combination of both options as per the best option trading strategies. To trade on best trading platform for option strategies you have to choose the right discount broker in India.
Also Read: How to Use Traderadar for Option Strategies as Market Conditions
You can choose the Moneysukh to opendemat and trading account for investing or trading into various market segments like equity, commodities and currencies. Here you can trade in all the segments including derivatives at the lowest brokerage charges baked with well-researched tips and recommendations to trade or invest in stocks, options and the forex market.
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