IMPLIED VOLATILITY – THE GAME CHANGER FOR OPTIONS PREMIUM
If I say “Change in implied volatility can have a greater impact on an option’s premium than the effects of delta, gamma, theta and rho combined” Sounds surprising?
But it’s true.
Have you noticed some time we pay too much premium for an options and sometime we get the same option with same strike considering same time left in expiry but still option’s premium is low, this is just because of volatility.
If Implied Volatility (IV) is low as compared to Historical Volatility (HV) then option are deflated.
As IV changes with dynamic crowd expectations (CALM-PANIC), the time value portion of the option premium inflates or deflates.
Let’s differentiate IV AND HV
|HISTORICAL VOLATILTY||IMPLIED VOLATILTY|
|Based on underlying||Based on Option price|
|Measurement of the speed in recent||Measurement of speed for future (EXPECTATION)|
|Measurement of speed for future (EXPECTATION)|
|Respond to crowd psychology and can move to unreasonable extremes|
IV increases during News, Event, Quarterly Results, Corporate Action etc.
The Traders Challenge:
Determining what is inflated and what is deflated?
Let’s take an example of balloon, suppose balloon is completely diffuse then we can say it is deflated and if start filling air in this it will start inflated, but at a certain point when the balloon completely filled with air and there are no more room for air then we can say it is super inflated and still if are we are trying to fill air, balloon will burst and start deflated.
Same with options, when people are in calm mode the volatility is deflated but when they come in panic mode volatility start increasing and may go to super inflated level. But at certain point it will start dropping when people will come again in calm mode after news or event then it will revert to the mean.
BUY -> DEFLATED OPTIONS
SELL -> INFLATED OPTIONS
INFLATED OPTIONS VS. DEFLATED OPTIONS
Options are priced based on the probability and expectations of price movement, therefore:
The higher the Implied Volatility, the higher the option’s premium for the same participation -> the higher the IV, the more inflated options: Options are expensive…And we love to sell them…
The lower the Implied Volatility, the lower the option’s premium for the same participation -> the lower the IV, the less inflated options: Options are cheap… And we love to buy them….
1 STD = ONE STANDARD DEVIATION (68% OF THE CASES)
As we all know this formula let’s take an example to understand this
Suppose Current Market Price of the Stock is 1450
HV IS 20.86 % AND IV IS 35.41% (in terms of %)
first of all need to convert it into terms of RS.
Based on the current HV the scrip has potential to move up or down Rs. 18.90 in a day, in 68 % of the cases (That would be a normal things to happen)
Based on the current Implied Volatility the scrip is expected to move up or down Rs. 32.09 in 1 day, in 68% of the cases (That would be a normal things to happen)
Implied Volatility Determines Strategy
IS IMPLIED VOLATILTY HIGH OR LOW?
The answer will determine which options strategy to use
|CONDITION||LOW IMPLIED VOLATILITY||HIGH IMPLIED VOLATILITY|
|If we are Bullish||We should net buyer of call options(Debit Strategies)||We should net seller of put options (Credit Strategies)|
|If we are Bearish||We should net buyer of put options (Debit Strategies)||We should net seller of call options (Credit Strategies)|