Why Implied Volatility is so Important in Options Trading?

If you are an options trader then understanding implied volatility (IV) is very essential for you to achieve success in the world of options. You must not go further in options trading until and unless you know everything about Implied Volatility (IV) because IV is a very important metric in options trading. As an options trader understanding what implied volatility represents, how to interpret implied volatility options and make trading decisions based on it is extremely important. In this blog, we are going to talk about implied volatility in detail. We are also going to tell you some of the most common terms related to implied volatility such as IV rank and IV percentile. Implied volatility can be an extremely confusing topic as a beginner. But after reading this blog you are going to have a solid understanding of what implied volatility actually represents. And we are fairly confident that you are going to realize that implied volatility is not as complicated as it may seem at first. So, let's start reading.

What is Implied Volatility (IV)?

Implied volatility represents the market’s expected magnitude for a stock’s future price movements. Implied volatility stems from a stock’s option prices which are implying how much volatility is expected from that stock going into the future. In its most simple form, Implied Volatility (IV) is determined by the current price of options contracts on a specific stock or future. It is represented as a percentage (%) that you can find under the options detail page.

How implied volatility represents the probabilities around a stock's price changes into the future?

Implied volatility represents the annualized expected one standard deviation (1 SD) range for the stock based on the options prices. When you look at any option chain, you will typically see that there is an implied volatility number associated with the expiration cycle and that implied volatility number is presented as a percentage figure but what does that percentage figure actually represent?

The first thing to know is that implied volatility is always expressed as an annualized percentage. So even if you are looking at 30-day option prices, the implied volatility number that you are looking at based on those 30-day option prices is annualized, meaning that they are taking the 30-day option prices and calculating implied volatility but they are calculating implied volatility over a one-year period from those 30-day option prices. More specifically the implied volatility percentage is the one standard deviation (1 SD) stock price range over the next year.

Standard Deviation in Stock Market

In statistics, one standard deviation (1 SD) range encompasses about 68% of potential outcomes around the mean or average. In the context of the stock market, the mean or average is the current stock price. The formula for the one year one standard (1 SD) deviation range is,

1-Year Expected Range = Stock Price + (Stock Price x Implied Volatility)

That may sound confusing but let me just quickly demonstrate with an example. Let’s consider Implied volatility (IV) of 25% on ABC stock priced at ₹200 will represent 1 standard deviation range (1SD) of ₹50 over the next year. ABC stock currently priced at ₹200 will sell between ₹150 and ₹250 one year from now. If you plot (see the image) this on the graph you can see that IV will not help a trader determine direction, it simply acts as a measure of uncertainty.

Importance of Implied Volatility (IV)

If we think about options contracts as insurance contracts, we can better understand the relationship between IV and an options price. When an asset’s future becomes more uncertain there is more demand for insurance on that asset. When this concept is applied to the stocks it just means that options, in general, will become more expensive as the market anticipates greater uncertainty about a stock’s performance in the future. This is why Implied Volatility (IV) is so incredibly important. In options trading, IV is very connected to an options price and directly impacts profits. In conclusion, IV is essentially a standardized way to measure the prices of options without actually having to analyze each different option’s price. Some traders will actually quote implied volatility as the price of an option rather than the listed contract price.

Relation between Implied Volatility (IV) & Options prices

The key point here is that market sentiment drives option prices and option prices drive implied volatility and from implied volatility, you can quickly gauge what the market sentiment is for a particular stock. So if a stock's option prices are expensive, let actually have high implied volatility which tells you that the market is expecting significant moves on that stock, on the other hand, if a stock's option prices are cheap then that stock is going to have lower implied volatility. This tells you that the markets expect smaller movements on that stock in the future.

Let's pretend for a second you live on a beach. If you see the water levels on the beach every day you can easily tell when the water levels are high and when they are low. A tourist, however, who comes to the beach for the very first time may think that an extremely high or an extremely low water level is perfectly normal, as he or she doesn't have any reference. Think of Implied Volatility as the water level. How can you place context around implied volatility and determine if it's high or low for a specific options contract? Well, the answer is simple,

Implied Volatility Rank (IV Rank) and Implied Volatility percentile helps conceptualize IV prices. So, you can have a good idea of whether things are expensive or cheap based on previous historic levels. Now let’s see IV Rank and IV percentile in detail.

Implied Volatility Rank (IV Rank)

This measurement ranges from 0 to 100 analyzing the high and low IV point over a certain time frame. Usually, one year is a timeframe that is used to measure IV.

Let's pretend you had an underlying that in the last year had an all-time low IV of 50% and an all-time high IV of 150%. The IV rank was 50, this will mean that the IV is currently 100%. If the current IV was above 150 % the rank would be 100 and if it was below 50% the rank would be zero.

As you can tell from this example IV rank essentially examines the historical highs and lows within a given period and shows all of the numbers that could be interpreted using a simple range i.e. 0 to 100.

But this measurement has a flaw that is concerning to many traders and is a big reason why many don't use this measurement for accurate referencing. Implied Volatility Rank (IV Rank) can be deceiving because of outliers.

For example, an earnings announcement may cause an underlying IV to spike to 200% just for one day. IV rank now includes this figure in its calculation and you are left with a deceiving stat that diminishes the value of what is trying to represent. Extreme outliers can significantly alter IV rankings to the point that they become essentially useless. This is why

many traders elect to use the IV percentile. This statistic weighs each day equally significantly minimizing the effects of outliers. That same spike mentioned where IV jumped up to 200% in one day now impacts the calculation, but it does so in such a smoother manner.

Implied Volatility (IV) percentile

IV percentile takes all the trading days in the past year and analyzes what percentage of those days IV was lower than the current level. This calculation provides a much clearer picture. It works in the same way with the range going from 0 to 100. We would suggest using the IV percentile to get the all-important context in regards to implied volatility in your next options trade. We advise you to install TALKDELTA software for your options trading. The TALKDELTA Option Hedging Software shows you the value of IV as well as many options parameters. You should use TALKDELTA to take your options trading to the next level.

To summarize the IV percentile, let us tell you the long story short with just one number. If the underlying XYZ has an IV of 40% and an IV percentile of 5%, we can safely assume that the IV is historically very low for this particular asset. On the other hand, if it was 40% and it had an IV percentile of 95%, we can safely assume it is very high.

Conclusion

Always remember the general rule that “Buy options when IV is low and sell options when IV is high”. Obviously, this is easier said than done. But many novice traders would simply glance over implied volatility without ever understanding it. By doing so they get crushed trying to make money by trading options. This is why understanding whether Implied Volatility (IV) is high or low is so incredibly important.