Table of contents:
- 0.1 Importance of implied volatility
- 0.2 No statements about the direction in which prices will move
- 0.3 Implied volatility using the example of a put
- 0.4 Implied volatility using the example of a call
- 0.5 How is the implied volatility calculated?
- 0.6 VDAX and VIX
- 1 Implied volatility and the IVR in options trading (2020)
- 1.1 The hen and the egg
- 1.2 Relationship between price development – underlying and options
- 1.2.1 The difference between price and value
- 1.2.2 Who or what drives the share price?
- 1.2.3 The burden of possession
- 1.2.4 This can be an option
- 1.2.5 Where can a risk be hedged?
- 1.2.6 Many strikes and many opinions
- 1.2.7 The common supports
- 1.2.8 An option reflects expectations
- 1.2.9 And then the price goes up
- 1.2.10 Where can I find options with high IV?
- 1.3 Summary for implied volatility
- 1.4 How can this be used for options trading?
- 1.5 The Implied Volatility Ranking helps to classify the current value
- 1.6 A basis for writer strategies
- 1.7 The IVR in the chart as short video
- 1.8 My conclusion on IV and IVR in options trading
The implied volatility in connection with options refers to the expected fluctuation margin of the underlying asset. It therefore makes statements about the expected price fluctuations over the remaining life of the option.
However, no statement is made as to whether the price will rise or fall. The implied volatility is given as a percentage on an annual basis.
The implied volatility changes constantly, in contrast to the historical volatility. The historical volatility is based on price fluctuations within a period of time in the past. They are therefore fixed.
The implied volatility expresses the current expectations of market participants with regard to the valuation of options. It includes the expected relationship between supply and demand.
Importance of implied volatility
Option prices are very strongly influenced by implied volatility. In general, it can be said that large price fluctuations always include the possibility that the share price could move strongly in a profitable direction for the owner of an option.
The options therefore gain value in the event of large fluctuations. This means that the option prices rise and the time value of the option increases. Conversely, falling implied volatility leads to a fall in option prices because, with regard to the underlying asset, only slight fluctuations in the price are expected until the end of the option’s term.
Investors should be aware that a decrease in volatility can lead to an enormous drop in the option price.
Simply explained: In quiet stock market times, without major fluctuations in share prices, buyers of options will not be prepared to pay high prices for options. If, on the other hand, strong price fluctuations are expected, the writer of an option will have the higher risk paid in the form of an increased option premium.
No statements about the direction in which prices will move
The volatility only stands for the range of the fluctuations. It makes no statement about the direction in which the underlying asset changes. A high implied volatility only stands for high expected fluctuations of the underlying asset. A low implied volatility, on the other hand, stands for low deflections. A high implied volatility therefore always means a high degree of uncertainty among investors about the expected price performance.
It is therefore also known as the “fear barometer”. If the majority of investors are certain that prices will move stably in one direction, there is low implied volatility.
However, it can also be stated that the implicit volatility is always higher when prices are generally falling than when prices are generally rising, because the rise in share prices is generally slower than the fall in prices in a pronounced bear market.
Implied volatility using the example of a put
The seller of a put option transfers the right to sell a share or other underlying asset at a price agreed today in the future to the buyer of the option and receives the option price in return. The buyer of the put option will only exercise the option if the actual price falls below the agreed purchase price or allows the option to expire.
The risk that the seller of the put option will actually have to buy the underlying shares at a higher price than the market price increases with increasing expected fluctuations in the share price.
The demand for corresponding put options will therefore increase accordingly. The implied volatility increases and, as a result, the option price for the higher risk on the part of the seller of the option also increases.
If, on the other hand, few fluctuations are expected, the buyers of the put option will be correspondingly less willing to pay higher option premiums, since there is relative certainty about the expected price development. Demand will fall accordingly.
Implied volatility using the example of a call
The seller of a call option transfers to the buyer the right to buy a share in the future at a price agreed today. The buyer will exercise his option if the share price rises above the agreed strike or otherwise allow it to expire.
If high fluctuations in the share price development are expected in the future, this means a higher risk for the seller of the call option that he must sell the underlying shares at a lower price than that actually available on the market. He will have the risk paid for with a correspondingly higher option premium. The demand for the corresponding call options will increase accordingly.
If, on the other hand, the market expects few fluctuations in the share price, the buyers of call options also see fewer chances of profiting from price changes and will therefore not be prepared to pay high option prices. In this case, the option prices will fall as demand falls.
How is the implied volatility calculated?
Implied volatility is calculated using the Black Scholes option pricing formula. In simple terms, it is the difference between the expected actual stock price and the exercise price. It takes into account the life of an option, the risk-free interest rate in the market, and the expected volatility.
The formula can therefore be resolved at any time according to volatility. However, option investors do not have to go through the trouble of calculating the implied volatility themselves. The value is available for each option from the options broker.
It is important, however, that investors understand the statistical relationship behind it. The information on implied volatility is based on the normal distribution. In relation to share prices, this means that on 68.27% of all trading days a fluctuation is within a standard deviation.
The share price can fluctuate upwards and downwards. Higher fluctuations are possible on 31.73 % of trading days.
If the implied volatility of an option is 16 %, this means that the underlying instrument is expected to fluctuate no more than 8 % up or down (16 % divided by 2) with a probability of 68.27 % (1 standard deviation) on an annual average.
The price fluctuation on one day is 1 %. The value of 16 % for the annual implied volatility is divided by 16. The divisor is the square root of 256 average trading days in the year, the basis of the calculation is the formula Formula for the standard deviation.
VDAX and VIX
The VDAX is the DAX volatility index, which reflects the implied volatility for the DAX expected by the futures markets, calculated on a notional option on the DAX with a term of 45 days.
The Chicago Board Options Exchange CBOE Volatility Index, which was established in 1993 by the Chicago Board Options Exchange, is an indicator of the implied volatility of index options on the S&P500 index with an assumed term of 30 days. The VIX is determined using in-the-money and out-of-money call and put options.
Implied volatility and the IVR in options trading (2020)
Building on the article on standard deviation, I would like to take a closer look at implied volatility (IV) in this paper. I will then draw the bow to the ranking of IV (IVR) and it goes into practice. With the corresponding key figures, a screening process can be established which also incorporates personal preferences for successful trading.
The hen and the egg
There are often misconceptions about the origin of implied volatility. At high IV, the prices of options rise. Or so it seems. With this thought, the well-known question of what came first: the chicken or the egg?
At least for the implied volatility I can unravel the thought carousel. Based on hindsight, we know that stock market prices will rise in the long run. If all market participants were now to agree on this, no stress situations could arise.
Relationship between price development – underlying and options
The difference between price and value
Now the valuations of a stock index are formed from a set of individual stock prices. Behind each price is an individual company. And the success of each company is based on actions that have taken place in the past. The sum of these actions has brought the company to the point where it now stands in the present.
The share price, on the other hand, often includes other factors. Then the true value of the company and the market value differ. If share buyers are convinced that the success of the company will continue in the future, they are also happy to pay a higher price.
Anyone who already owns the shares does not want to sell them yet, of course. The prospects for further profits are too tempting. As a result, the supply of shares is scarce. At the same time, demand is increasing due to new interested parties. This situation also leads to a rise in the price of shares in the company: the share price.
In addition to private investors, funds and, for example, pension insurance companies are also invested in shares. Certain ETFs also buy blocks of shares to track an index.
As a result, a whole lot of shares are tied to their owner in one way or another. The reasons for holding a share can be many and varied:
- Buy and hold investors look at dividend payments rather than price performance
- Funds cannot sell their usually very large positions at once, the price would collapse
- Private investors hope for further gains or do not want to realize losses
- ETFs hold the share as long as it is listed in the index
- and surely there are many more individual reasons
However, the examples given have one thing in common:
The burden of possession
With the mere possession of the shares, all market participants are exposed to the risk of falling prices. Should a sales panic set in, an excessive supply meets a hardly existing demand. The prices fall into a bottomless pit. In such cases, trading is often suspended by the stock exchange. This gives the market makers time to calculate a halfway realistic price on the basis of the accumulated orders.
Accordingly, share owners should have a need to hedge their positions. A proven method used by investment companies, funds and also private investors is hedging via options.
This can be an option
Options are created by the futures exchanges. They are standardised, and fair buying and selling prices are always quoted by the market makers. These prices are based on the market value of the underlying asset. On the other hand, and this is the more important part, they are based on the relationship between supply and demand for the individual option.
We know from the basic series on option trading that the price of an option consists of two components:
- Options in the money have an intrinsic value (depending on the price)
- All options have a time value (depending on various factors)
- The variables that influence the fair value are taken into account by the market makers when setting prices. In addition, something else happens when there is an increased need for hedging: the demand for certain options increases.
Where can a risk be hedged?
Just as support and resistance can be found in the chart of a share, market participants also look for corresponding options on these brands. I always like to use the Apple share as an example. In the following chart, the 330 dollar mark is outstanding.
The beginning of the year was the all-time high in this area. Then nobody could estimate the consequences of a globally declared pandemic. Everyone wanted to secure profits, have liquid funds or simply limit their losses.
The panic bottomed out at 210 dollars. Confidence in future profits returned and demand increased. The $330 mark, the previous all-time high, has created resistance. This was overcome by the newly established upward trend after a sideways phase with minor fluctuations.
Many strikes and many opinions
Currently Apple has generated a new all-time high of $399.82. The $400 mark was literally missed by a hair’s breadth. Would you also want to hedge an existing stock position at the sight of the current day candle?
Based on the individual entry price, a trader usually wants to hedge his profits. In the best case he does not want to get into the loss zone. When a downward movement occurs, the classic supports come into focus first.
The common supports
The first stop would be the 20 or 21 moving average. Then follows the 50 GD as a frequently reliable safety zone. Then come the last local lows and combinations of past highs and lows.
The 330 mark should now provide strong support. The gap to the current price is relatively large. As a hedge, the purchase of a put option with just this strike price would be a good idea. Since such brands are observed by a large part of the market participants, the puts with this strike would be in greater demand.
In the quantity of all orders, the normal distribution would then also come into play again. An average value is extracted from all the strike prices of the options in demand. The strike closest to this value would be the option with the highest order density.
An option reflects expectations
Even though there are still many different terms for the options at this strike, a specific expiration date is crystallized from the average of all orders.
Now the market maker on the futures exchange is in demand. He represents a middleman who must determine a price from supply and demand. At the same time, he undertakes to buy and sell at the prices quoted. If there is no supply for the corresponding option, he cannot pass on the risk. He has to sell the options from his portfolio, which causes an imbalance in his portfolio.
To cushion his risk, he will raise the price of the option. This is legitimate and the natural result when supply and demand drift apart. This creates an individual price for each option.
And then the price goes up
This is exactly where the implied volatility comes into play. The change in the option prices is used to determine the measure of the future fluctuation margin of the underlying asset. This snapshot thus projects a possible price development into the future.
In my chart settings of the TWS I let the first standard deviation be displayed as assumed price targets. This allows relevant strikes to be read off more quickly. An example of such a chart can be found in the following picture:
In the lower area the implied volatility is displayed. Here you can see the development of the option prices of the underlying instrument displayed. Based on this, I also interpret the IV as a measure of the uncertainty prevailing in the underlying.
Where can I find options with high IV?
There is a filter option on barchart.com. This allows you to search for options accordingly. Depending on the desired strategy, the results will help you to analyze the underlying asset. You can find the screener directly under this link.
Summary for implied volatility
- Expectations of the price performance of the underlying instrument can be implemented with options (call and put)
- Supply and demand for options affect their prices
- The price changes of the options then form the value for the implied volatility
How can this be used for options trading?
As an indicator, IV has proven its worth by putting it in relation to the course of the past 52 weeks. Over the course of a year, the underlying instrument goes through different cycles. Added to this are the expectations at the reporting dates: On the US market, companies have to publish their annual report once a quarter.
In the period prior to this earnings date, speculation about earnings is rife. Analysts try to estimate the development and interpret current information in terms of earnings. Depending on the news situation, uncertainty also forms here, which is reflected in the option prices.
The Implied Volatility Ranking helps to classify the current value
Over time, a high and a low value for IV is formed here. Within this range, the implied volatility usually runs between the dates. The current value in relation to the high-low range is called “IVR”. The abbreviation stands for Implied Volatility Rank(ing).
Corresponding columns can be inserted in the TWS. The IVR can then be calculated from this using a formula. Practically, the IVR can also be displayed in the TWS. I have inserted the columns once for the example to derive the formula:
The formula for the IVR
- The IVR results from = ( Current IV – 52 Wo.Low) * 100) / ( 52 Wo. High – 52 Wo. Low)
- with the values from the example we get
- (( 2,36 % – 1,081 % ) * 100 ) / (5,673 % – 1,081 %) = 27,853 %
from this we get the 28 from the column “52-week IV-ranking” rounded to the whole
The current value for implied volatility is thus at 28% of the high and low range of the last 52 weeks.
A basis for writer strategies
Suitable for option strategies with a risk buffer are combinations that profit from a decline in fair value. These strategies, in which the trader acts as a writer, work best when premiums are high. This has two advantages:
At high premiums, the break-even is further from the current entry price
The chance of a decrease in IV is greater with a high IVR
Can the IVR go over 100?
Normally IV tends to go towards the mean, which would mean an IVR of 50. Nevertheless, even with a high IVR of 80, for example, the values can still skyrocket. However, the IVR would not rise above 100, because in this case the 100% would be marked by the current peak value.
The value for this moment is then the highest in the last 52 weeks. This situation was the case for Apple in the rising IV towards the end of March.
The IVR in the chart as short video
In addition to the article I explain the IV and IVR also in this short video
My conclusion on IV and IVR in options trading
For trading in options, we can make the following rule of thumb at this point:
- BUYING options at low IVR (values below 30 are optimal)
- Selling options at high IVR (values above 45 are optimal)
In the strategies I trade, a combination with the chart image is used. If the chances are good, I also accept an IVR around 37. Often the combination of premium and risk settles at similar values when looking at the pure price.
Furthermore, the distance to the earnings date or other binary events is also important. The expiration date of my basic strategies is always before the earnings date or relevant news. In the case of a pharmaceutical company, for example, this could be the approval of a drug.
Read my other posts about options:
- Bear Call Spread Options Strategy
- Bull Put Spread – Earn Money With Puts And Limit Risk
- Butterfly Spread Options Strategy
- Definition Of Option Price/Option Premium
- Earn Money With A Covered Call Options Strategy
- How to exercise Options
- How to use the Standard Deviation for Options Trading
- Iron Condor – Profit From Low Price Fluctuations
- Options Trading Tutorial for beginners
- Options vs. Futures – Two Different Types Of Futures Contracts
- Options vs. Warrants – 4 Differences
- Protective Put – Hedging Of Equity Positions
- Simple Trading Strategies for Options
- Term structure options
- What are options? – Explained Simply And Quickly
- What is a Long Call in Options Trading?
- What is a Long Put in Options Trading?
- What is a Short Call in options Trading?
- What is a Short Put in Options Trading?
- What is delta in Options Trading? – The Most Important Key Figure
- What is Historical Volatility in Options Trading?
- What is the Gamma in Options Trading?
- What is the Implied Volatility Of Options – Important Or Not?
- What is the Theta in Options Trading?
- What Is The Vega Of An Option?