Implied Volatility in Options

Implied volatility is expressed as a percentage of the stock price, indicating a one standard deviation move over the course of a year. For those of you who ... /*changedittoh3becausecufon.jswouldn'tstopoverridingh1andh2htmltags*/?> ImportantNotice You'releavingAllyInvest Bychoosingtocontinue,youwillbetakento,asiteoperatedbyathirdparty.Wearenotresponsiblefortheproducts,services,orinformationyoumayfindorprovidethere.Becauseyou’releavingAllyInvest,we’dlikeyoutoknowthatthisthirdpartyhasitsownprivacypolicyandlevelofsecurity.Weencourageyoutoreviewanypolicyandanytermsandconditionspostedonthatsite.    Home OptionsBasics Rookie'sCorner OptionStrategies ManagingPositions Glossary Whatisvolatility? Orwhyyouroptionpricescanbelessstablethanaone-leggedduck Sometradersmistakenlybelievethatvolatilityisbasedonadirectionaltrendinthestockprice.Notso.Bydefinition,volatilityissimplytheamountthestockpricefluctuates,withoutregardfordirection. Asanindividualtrader,youreallyonlyneedtoconcernyourselfwithtwoformsofvolatility:historicalvolatilityandimpliedvolatility.(Unlessyourtempergetsparticularlyvolatilewhenatradegoesagainstyou,inwhichcaseyoushouldprobablyworryaboutthat,too.) Historicalvolatilityisdefinedintextbooksas“theannualizedstandarddeviationofpaststockpricemovements.”Butratherthanboreyousilly,let'sjustsayit’showmuchthestockpricefluctuatedonaday-to-daybasisoveraone-yearperiod. Evenifa$100stockwindsupatexactly$100oneyearfromnow,itstillcouldhaveagreatdealofhistoricalvolatility.Afterall,it’scertainlyconceivablethatthestockcouldhavetradedashighas$175oraslowas$25atsomepoint.Andiftherewerewidedailypricerangesthroughouttheyear,itwouldindeedbeconsideredahistoricallyvolatilestock. Figure1:Historicalvolatilityoftwodifferentstocks Thischartshowsthehistoricalpricingoftwodifferentstocksover12months.Theybothstartat$100andendat$100.However,thebluelineshowsagreatdealofhistoricalvolatilitywhiletheblacklinedoesnot. Impliedvolatilityisn’tbasedonhistoricalpricingdataonthestock.Instead,it’swhatthemarketplaceis“implying”thevolatilityofthestockwillbeinthefuture,basedonpricechangesinanoption.Likehistoricalvolatility,thisfigureisexpressedonanannualizedbasis.Butimpliedvolatilityistypicallyofmoreinteresttoretailoptiontradersthanhistoricalvolatilitybecauseit'sforward-looking. Wheredoesimpliedvolatilitycomefrom?(hint:notthestork) Basedontruthandrumorsinthemarketplace,optionpriceswillbegintochange.Ifthere’sanearningsannouncementoramajorcourtdecisioncomingup,traderswillaltertradingpatternsoncertainoptions.Thatdrivesthepriceofthoseoptionsupordown,independentofstockpricemovement.Keepinmind,it’snottheoptions’intrinsicvalue(ifany)thatischanging.Onlytheoptions’timevalueisaffected. Thereasontheoptions’timevaluewillchangeisbecauseofchangesintheperceivedpotentialrangeoffuturepricemovementonthestock.Impliedvolatilitycanthenbederivedfromthecostoftheoption.Infact,iftherewerenooptionstradedonagivenstock,therewouldbenowaytocalculateimpliedvolatility. Impliedvolatilityandoptionprices Impliedvolatilityisadynamicfigurethatchangesbasedonactivityintheoptionsmarketplace.Usually,whenimpliedvolatilityincreases,thepriceofoptionswillincreaseaswell,assumingallotherthingsremainconstant.Sowhenimpliedvolatilityincreasesafteratradehasbeenplaced,it’sgoodfortheoptionownerandbadfortheoptionseller. Conversely,ifimpliedvolatilitydecreasesafteryourtradeisplaced,thepriceofoptionsusuallydecreases.That’sgoodifyou’reanoptionsellerandbadifyou’reanoptionowner. InMeettheGreeks,you’lllearnabout“vega”,whichcanhelpyoucalculatehowmuchoptionpricesareexpectedtochangewhenimpliedvolatilitychanges. Howimpliedvolatilitycanhelpyouestimatepotentialrangeofmovementonastock Impliedvolatilityisexpressedasapercentageofthestockprice,indicatingaonestandarddeviationmoveoverthecourseofayear.ForthoseofyouwhosnoozedthroughStatistics101,astockshouldendupwithinonestandarddeviationofitsoriginalprice68%ofthetimeduringtheupcoming12months.Itwillendupwithintwostandarddeviations95%ofthetimeandwithinthreestandarddeviations99%ofthetime. Figure2:Normaldistributionofstockprice Intheory,there’sa68%probabilitythatastocktradingat$50withanimpliedvolatilityof20%willcostbetween$40and$60ayearlater.There’salsoa16%chanceitwillbeabove$60anda16%chanceitwillbebelow$40.Butremember,theoperativewordsare“intheory,”sinceimpliedvolatilityisn’tanexactscience. Let'sfocusontheonestandarddeviationmove,whichyoucanthinkofasadividinglinebetween“probable”and“not-so-probable.” Forexample,imaginestockXYZistradingat$50,andtheimpliedvolatilityofanoptioncontractis20%.Thisimpliesthere’saconsensusinthemarketplacethataonestandarddeviationmoveoverthenext12monthswillbeplusorminus$10(since20%ofthe$50stockpriceequals$10). Sohere’swhatitallboilsdownto:themarketplacethinksthere’sa68%chanceattheendofoneyearthatXYZwillwindupsomewherebetween$40and$60. Byextension,thatalsomeansthere’sonlya32%chancethestockwillbeoutsidethisrange.16%ofthetimeitshouldbeabove$60,and16%ofthetimeitshouldbebelow$40. Obviously,knowingtheprobabilityoftheunderlyingstockfinishingwithinacertainrangeatexpirationisveryimportantwhendeterminingwhatoptionsyouwanttobuyorsellandwhenfiguringoutwhichstrategiesyouwanttoimplement. Justremember:impliedvolatilityisbasedongeneralconsensusinthemarketplace—it’snotaninfalliblepredictorofstockmovement.Afterall,it’snotasifNostradamusworksdownonthetradingfloor. Whichcamefirst:impliedvolatilityortheegg? Ifyouweretolookatanoption-pricingformula,you’dseevariableslikecurrentstockprice,strikeprice,daysuntilexpiration,interestrates,dividendsandimpliedvolatility,whichareusedtodeterminetheoption’sprice. Marketmakersuseimpliedvolatilityasanessentialfactorwhendeterminingwhatoptionpricesshouldbe.However,youcan’tcalculateimpliedvolatilitywithoutknowingthepricesofoptions.Sosometradersexperienceabitof“chickenortheegg”confusionaboutwhichcomesfirst:impliedvolatilityoroptionprice. Inreality,it’snotthatdifficulttounderstand.Usually,at-the-moneyoptioncontractsarethemostheavilytradedineachexpirationmonth.Somarketmakerscanallowsupplyanddemandtosettheat-the-moneypriceforat-the-moneyoptioncontract.Then,oncetheat-the-moneyoptionpricesaredetermined,impliedvolatilityistheonlymissingvariable.Soit’samatterofsimplealgebratosolveforit. Oncetheimpliedvolatilityisdeterminedfortheat-the-moneycontractsinanygivenexpirationmonth,marketmakersthenusepricingmodelsandadvancedvolatilityskewstodetermineimpliedvolatilityatotherstrikepricesthatarelessheavilytraded.Soyou’llgenerallyseevariancesinimpliedvolatilityatdifferentstrikepricesandexpirationmonths. Figure3:Optionpricingcomponents Hereisalltheinformationyouneedtocalculateanoption’sprice.Youcansolveforanysinglecomponent(likeimpliedvolatility)aslongasyouhavealloftheotherdata,includingtheprice. Butfornow,let’sstayfocusedontheimpliedvolatilityoftheat-the-moneyoptioncontractfortheexpirationmonthyou’replanningtotrade.Becauseit’stypicallythemostheavilytradedcontract,theat-the-moneyoptionwillbetheprimaryreflectionofwhatthemarketplaceexpectstheunderlyingstocktodointhefuture. However,watchoutforoddeventslikemergers,acquisitionsorrumorsofbankruptcy.Ifanyoftheseoccuritcanthrowawrenchintothemonkeyworksandseriouslymesswiththenumbers. Usingimpliedvolatilitytodeterminenearer-termpotentialstockmovements Asmentionedabove,impliedvolatilitycanhelpyougaugetheprobabilitythatastockwillwindupatanygivenpriceattheendofa12-monthperiod.Butnowyoumightbethinking,“That’sallfineanddandy,butIdon’tusuallytrade12-monthoptions.Howcanimpliedvolatilityhelpmyshorter-termtrades?” That’sagreatquestion.Themostcommonlytradedoptionsareinfactnear-term,between30and90calendardaysuntilexpiration.Sohere’saquickanddirtyformulayoucanusetocalculateaonestandarddeviationmoveoverthelifespanofyouroptioncontract—nomatterthetimeframe. Figure4:Quickanddirtyformulaforcalculatingaonestandarddeviationmoveoverthelifeofanoption Remember:thesequickanddirtycalculationsaren’t100%accurate,mainlybecausetheyassumeanormaldistributioninsteadofalognormaldistribution(see“ABriefAside”below).They’remerelyhandyingraspingtheconceptofimpliedvolatilityandingettingaroughideaofthepotentialrangeofstockpricesatexpiration.Foramoreaccuratecalculationofwhatimpliedvolatilityissayingastockmightdo,useAllyInvest’sProbabilityCalculator.Thistoolwilldothemathforyouusingalognormaldistributionassumption. Thetheoreticalworldandtherealworld Inordertobeasuccessfuloptiontrader,youdon’tjustneedtobegoodatpickingthedirectionastockwillmove(orwon’tmove),youalsoneedtobegoodatpredictingthetimingofthemove.Then,onceyouhavemadeyourforecasts,understandingimpliedvolatilitycanhelptaketheguessworkoutofthepotentialpricerangeonthestock. Itcan’tbeemphasizedenough,however,thatimpliedvolatilityiswhatthemarketplaceexpectsthestocktodointheory.Andasyouprobablyknow,therealworlddoesn’talwaysoperateinaccordancewiththetheoreticalworld. Inthestockmarketcrashof1987,themarketmadea20standarddeviationmove.Intheory,theoddsofsuchamovearepositivelyastronomical:about1inagazillion.Butinreality,itdidhappen.Andnotmanytraderssawitcoming. Althoughit’snotalways100%accurate,impliedvolatilitycanbeausefultool.Becauseoptiontradingisfairlydifficult,wehavetotrytotakeadvantageofeverypieceofinformationthemarketgivesus. ABriefAside:NormalDistributionvs.LogNormalDistribution Alloptionpricingmodelsassume“lognormaldistribution”whereasthissectionuses“normaldistribution”forsimplicity’ssake. Asyouknow,astockcanonlygodowntozero,whereasitcantheoreticallygouptoinfinity.Forexample,it’sconceivablea$20stockcangoup$30,butitcan’tgodown$30.Downwardmovementhastostopwhenthestockreacheszero.Normaldistributiondoesnotaccountforthisdiscrepancy;itassumesthatthestockcanmoveequallyineitherdirection. Inalognormaldistribution,ontheotherhand,aonestandarddeviationmovetotheupsidemaybelargerthanaonestandarddeviationmovetothedownside,especiallyasyoumovefurtheroutintime.That’sbecauseofthegreaterpotentialrangeontheupsidethanthedownside. Unlessyou’rearealstatisticsgeek,youprobablywouldn’tnoticethedifference.Butasaresult,theexamplesinthissectionaren’t100%accurate,soit’snecessarytopointitout. Backtothetop Introduction OptionsBasics KeyOptionsTerms ABriefHistoryofOptions WhatisVolatility? MeettheGreeks WhatisanIndexOption? CashingOutYourOptions KeepingTabsonOpenInterest ThePlayersintheGame UpcomingWebinars Learntradingtips&strategiesfromAllyInvest’sexperts Top10OptionTradingMistakes TradingOptionsforBeginners HowtoWriteCoveredCalls:4TipsforSuccess PutOptionsExplained BullishandBearishOptionTradingStrategies WhatisImpliedVolatility UnderstandingOptionGreeks&Dividends TradingOptionsinanIRA