The market is volatile. Volatility is an important component of the markets that captures the uncertainty in asset values and investor sentiment. When making a trade, it’s important to know what volatility appears to be on any given day or hour and how likely the implied volatility is to increase over time.
An increase will ultimately affect the options premium you receive or payout when initiating a trade. For instance, you may sell a call option that appears high on the day you sold it, but that option may decrease in value and ultimately result in a loss over time.
What is Implied Volatility?
It is the level of volatility expected by traders over the near future. It is expressed as the average of the implied volatilities on options with time to expiration that expire shortly, or in put-call parity terms, as the comparison of option premium prices to spot price.
According to tastytrade, Implied volatility is typically represented in percentage terms, but it can also be represented graphically in the so-called “Volatility Skew”. The volatility skew is a representation of it. The implied volatilities across different expirations tend to form an asymmetrical or skewed distribution pattern when plotted on a chart.
Why it is Important?
1. If Its Security Increases, Then its Option Price Can Also Increase.
If a trader is long insecurity and becomes more volatile, then the value of their option can increase. This is in contrast to when the volatility decreases when the value decreases. Thus, if you are long in the security, you want volatility to increase- this will have a positive impact on your holdings.
2. When it is High, Options are Generally More Expensive.
When a security is in a period of low volatility, the unstated volatility in that security will be below. This will give you a lower current price for your option. When there is a high level of volatility, it is usually higher- this will give you a higher option price when there is no fundamental reason to expect this to happen.
3. It Can Affect Long and Short Positions in the Same Way.
unstated volatility, just like the stock price, is affected by fundamental factors. If any of these factors change, then the volatility may also change. For instance, if the news is released that tells traders that a company will be releasing their earnings on April 25th, then unstated volatility for this security should increase due to the uncertainty of how the stock will react to this announcement. This, in turn, can result in higher option prices.
How to Measure It When Trading Options.
1. It Is Measured Using the Black-Scholes or Binomial Options Pricing Model.
It is calculated by plugging in the assets price and strike prices and then adjusting for the risk-free rate and option life. A table of calculations will then be created, showing you how different price changes will affect your option premium.
2. It Can Also be Calculated Directly From Historical Prices.
This is very similar to the calculations done by the Black-Scholes pricing model, but it uses actual historical data. This method has fewer input variables, so it is easier to calculate. However, it is not as accurate as the Black Scholes option model.
It is important as it can help us understand the value of an option and inform our trading decisions. When we introduce it into our trading strategy, we need to be aware of how it works and the impact that it has on our positions.