Trading is extremely competitive. Implied volatility is one way to gain an edge.
Implied volatility, or IV, is one of the most important ideas in options trading. Traders need to understand. It shows how volatile financial markets might be in the future. It can also assist you in calculating probability. However, it’s important to note that it does not provide a forecast. There is no guarantee that it will be correct.
Implied volatility is forecasted by an option pricing model. The data is purely theoretical. Think of it like a weather forecast.
Unfortunately, some mislead traders use it incorrectly. They use IV to find cheap stocks or believe the numbers are over-inflated. They haphazardly assume that IV levels are too extreme. Remember, IV figures are from a model. They’re determined by the volatility of the current market.
Historical Volatility
If you turn on CNBC, you might hear the term “historical volatility”. IV is a different figure. Historical volatility is the annualized standard deviation of stock prices in the past. It shows the daily changes in the stock over the past year. Historical volatility is better at showing the larger, long-term picture. On the other hand, it might not show a recent issue like a court case or a big change in earnings.
Implied Volatility
Implied volatility is one of the most important numbers in options trading. It’s taken from the option price. It displays what the market is hinting at about the volatility in the future.
In the popularly used option pricing model, implied volatility is one of six variables. IV can only be calculated by knowing the other five inputs and solving for them.
How is this determined? Most of the trading volume on options exchanges happens at-the-money (ATM). These contracts are used to calculate the figure of IV. Since we are aware of the price of ATM contracts, we can use the options pricing model and some simple math to calculate IV.
It’s important to note that market makers or exchanges don’t set the price of implied volatility. They look at actual order flow. When combined with the options model, they’re able to determine a figure for implied volatility.
Implied Volatility as a Trading Tool
According to TastyTrade, options are insurance contracts. If IV goes up, the higher options premium goes. It can be more lucrative to sell options. For example, if you own the stock and want to sell covered calls, a higher IV means more cash.
If you’re looking to generate income, IV should be one of your primary tools in locating good candidates.
IV can also be an objective method at forecasting and finding entry and exit points. It can tell you whether the market agrees or disagrees with your perspective.
How Implied Volatility Can Reflect Market Risk
Volatile markets can sometimes mean big losses. By keeping track of implied volatility, you can see what the options model is predicting because it is directly related to market risk.
If you’re someone particularly averse to risk, you can examine the IV of your portfolio. Exiting your high-IV stocks might not be a bad idea.
IV stock is a great tool. Every options trader should know about it.
