Implied Volatiliy- the stealth factor of option trading

Here you go- I tried to simplify it as much as I could so that I dont make it too complex and mathematical. Options are a wonderfool tool- like a Knife you can either save a life with it or Kill someone! That is not the fault of the knife!




I am sure there are technical books on a lot of these things. But I will put my thoughts down on Implied Volatility- as it is one of the most critical options parameters- and is normally not understood.

Every asset has a certain trend in prices over time- assuming it is a liquid market. This can captured by what is called aptly- Statistical or Historical volatility. Higher this number the more volatile the price of the underlying asset. Remember this is a number- given the data- anyone can compute. Typically you take a 50 Day average- but the idea is that you should know what this means. This is very significant.

We then move on to option pricing- the standard one that is used is the Black-Scholes Model ( and won a Nobel Prize for this work) which is the backbone of modern financial thinking. There are other models but let us just this is the most popular.

Per this model Option Price is a function of ( Underlying price of the asset, Historical Volatility, Risk free Interest rate, Dividends, and Of course the Strike Price). So it is Important for people who just use the Index and stock levels to trade options- the serious mistake they are perhaps making ( as you can see Underlying price of the asset is JUST ONE of the factors that influence price- you basically are ignoring several others!)

Risk Free Interest rate- is typically a short term rate on Government securities. In the US it is typical to use the 90 day treasury bill. I understand in India they use the MIBOR rate.
Typically a 90 day rate is fine- because most traders square off within 3 months or trade in the 3 month window. If for example you are trading option for a longer duration- you should change the rate that to a longer tenor. This typically is not much of a factor unless the government changes the rates.

Dividends are explanatory- so you need to be careful in India- as even tech stocks there are dividend paying companies.
I would assume you know what “Strike Price” means.


Now what the heck is IV ( or Implied Volatility)?

A very fundamental issue. So let me be very simplistic and explain.
As you have seen above Option prices are affected by volatility of the stocks- this is the statistical volatility- and this volatility varies with market conditions ( which we currently now see!) or stock specific news. This leads to temporary inflation of option prices- as they no longer seem to go with normal historical volatility levels!

Here is the concept:

We use B-S model for calculating Theoretical Prices of options? Now if I have the option price ( form live quotes) can I make a guess on what Volatility level that quote is taking into account? In other words- you calculate backwards- i.e. we now have a live quote for an option- and we try and get what Volatility that live quote is suggesting! This the mighty weapon called “Implied Volatility”. In essence it is like a thermometer that you use to check if you have fever- and is a very important factor for success.

Now if the IV that you get is greater than what Historical Volatility of the asset is- it gives you a neutral assessment of what is expected- if say the IV is very high- all it suggests is that options are “expensive”- it does not tell you which direction the stock will move!
So it boils down to this- are the options you are planning on buying- “cheap” ( this is when IV levels trail Historical Volatility) or ‘Costly ‘ ( When IV is far greater than Historical volatilities). And basically you want to buy things at a reasonable price in general! Also please remember- it is the percentile of IV that matters- just being slightly over the historical does not tell you much. But if you trade options- you have to know IV- make it your friend and you will do well or at least avoid obvious mistakes.

While all this seems a lot of work- but if you have a good options software package all this is already done for you.- hence my lament that there is no real effort to involve the common guy- it seems it is only meant for institutional traders for portfolio hedging. Trust me if you get yourself familiar with this- you will learn to do better than the big boys- as you can do with smaller trade sizes.


A lot of you wanted books to read- true you need to understand basic options terminology- you will do well to go to CBOE and just understand basics. Natenberg as good book on Implied volatility- there are a lot of them. The best one I read- and which really gives a whole different meaning- was Charles Cottle’s “Woulda, Coulda, Shoulda- options Perceptions and Deceptions- this is not a book you can read easily- but if you do get the import of what is being said ( although it is written for Market Maker’s in options)- it is a fantastic treasure. It is available as a free download- and trust me I would have happily paid for it. The best thing about this one- is gives you a practical dimension on pricing- and most importantly how to change your initial positions and adjust


The next installment will be one Delta- one of the Greeks and perhaps something that is only second in importance to IV. ( Delta, Theta, Gamma, Rho- are the four measures called “Greeks”- as they are letters of the Greek Alphabet. And are fairly common if you are a student of advanced mathematics- well not necessarily advanced!)

Prem,

After a decade- I am still a student! I cannot tell you what your position will make or lose- that is something that depends on some inputs that are missing.

If you go to any decent options calculator- and enter all the variables- strike, option price, interest etc- you will get a volatility figure ( assuming you do not enter any values)- that is your IV. Compare this IV to the the Historical Volatility of the Index- and all you can tell is whether your purchase was "cheaper" or "expensive"

You will make money on the factors- mentioned in my write up above- for example if the index were to drop below 4200 by sept expiration ( or anytime before that). Per my analysis the Index has resistance at 4400 ( secondary at 4500)- and support at 4100. So theoretically you still have a shot!

You have to first make sure your expectation since you bought the option still hold true- if you are still convinced hang on to it- for example if you now feel the market is not going to drop and in fact go up ( now you are basically changing to a bullish sentiment)- then you would want to sell a higher put and create a spread ( credit spread)- but I am not sure how your broker will margin that in India.

The important thing is to evaluate your initial assumptions- and ask the question " do I still believe the same thing as I did since I bought the original put" If the answer is yes- then stand pat- if you changed then you adjust your position.

IV just tells you one part of the story- but it is an important part.

Hi Srikanth,

Excellent. Please tell us about some IV calculators on the web.

Thanks,

ss

gr8 beginning Srikanth thanks

very nice **bows to the great one**

Saw this write up with example of IV on icici : (check the link)

http://content.icicidirect.com/ULFil...0041111736.asp

BUt no(IV) could be considered as the option as expensive or cheap