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The mathematics involved in trying to figure out how the financial markets tick is simply mind-boggling.
People devote their entire lives to studying different ways to gather data and express how markets move with equations, indicators, and strategies.
We will not be discussing these topics. Your brain would, quite simply, melt.
However, there is one very important figure deeply rooted in the pricing of financial assets that we will be discussing – implied volatility.
What is it? Why should you care? Can it make you money? Let’s answer those questions and more.
What is Implied Volatility (IV)?
The definition is quite simple – implied volatility measures how much the value of an options contract will move up or down given a specific period of time. It is calculated based on the previous 1 year of pricing data and is usually written as a percentage.
It is mostly used in the pricing of stock options since options lose value as they approach expiration.
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How Does Implied Volatility Work?
In practice, the concept of IV couldn’t be any more complicated. The definition implies that a computer can tell you about the range within which a stock will move given a period of time.
If this were true 100% of the time, you’d bet your entire life savings that the options contract would stay in that range and win every time.
Obviously, this doesn’t happen. Why then are we discussing it? The answer is that IV can give investors good guidance about market sentiment for a particular underlying stock.
Let’s look at an example.
If you’re looking at an option where the underlying is priced at $60 and IV is showing 25%, then the market is telling you that, all other things being equal, the underlying is likely to move somewhere between $45 and $75 ($15 or 25% away from the current price).
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Is High Implied Volatility Good or Bad?
Think of IV as the thermometer of the financial markets. A thermometer can’t tell you what’s going on inside the body.
All it does is tell you whether you should be more concerned or if things are relatively stable.
As the temperature reading goes up, it tells you that you should start focusing on figuring out the next steps.
While IV may not necessarily be a bad thing like a rising temperature reading on a thermometer, high IV generally has bearish (falling price) connections.
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What Is Considered Low Implied Volatility?
Low IV can give investors some idea that a stock might either maintain a tight range or keep creeping up in value.
If the volatility drops below 20%, this is generally considered low, and the underlying stock is expected to stay relatively stable or slowly increase in the near term.
How Does Implied Volatility Affect Options?
IV is one part of nearly all options pricing models currently in use. In addition to IV, options are priced based on current stock price, the option’s strike price, time until expiration, and the current risk-free rate.
We won’t scare you away by copying the hideous equation in this article, but it’s worth noting that the price of an options contract has a direct correlation to implied volatility.
That is, as implied volatility increases, so does the price of the options contract, even if the underlying price doesn’t move.
What Factors Affect Implied Volatility?
#1. Company News
If you really want to see volatility in action, pick a stock where the company is just about to announce its next earnings report.
Follow the IV for that stock all the way until earnings are reported. Once earnings are reported, there is usually what’s called a “volatility crush.”
Company earnings are important to investors, and they are generally unknown until they are announced. After the announcement, there is less uncertainty and, by extension, lower volatility.
#2. Supply and Demand
Supply and demand affect nearly everything in the finance world, so it’s natural that IV would be no different.
When you see a stock in high demand suddenly – such as the meme stock runs recently – there will be huge spikes in price because of the spike in buying (demand) of that stock.
This causes a spike in IV as well. It goes both ways, so high supply and low demand of shares would decrease IV.
#3. Time Value
This metric is specific to the options market and is also a part of the pricing equations.
With each passing day, the option’s IV falls because (all other things being equal) it becomes less likely that price will spike one way or another.
If you compare IV at 60 days from expiration and 1 day to expiration, the latter is usually quite a bit lower.
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Example of Implied Volatility in Action
The problem with IV is that it is not like the time until expiration where it is clearly defined. In fact, IV is the only input in the pricing models that changes constantly based on market inputs we discussed earlier as well as others.
However, let’s show an example of volatility and its effect on the price of an option contract.
CrowdStrike (NASDAQ: CRWD) just announced earnings after market close yesterday (as of this writing, Sep 1, 2021).
The underlying stock price was $281.00 at closing with an IV of 31.6%. This means that the stock should move within a range of 31.6% of the stock price over the course of the next year.
This calculates to about $88 up or down from current price, and the closest we can get at this time is the Jun 17, 2022, option contracts, which are showing about $86 up or down as the potential range, or IV, of the stock, were you to buy a contract in that expiration month right now.
On the stock market’s opening (first day of trading after earnings), IV actually went up to 34.8%. This is because the stock price went down more than $10 and came back up to around $281 at the opening.
While IV sometimes drops after earnings, this shows that it isn’t always clear how events will affect IV and, by extension, the price of stock options.
Pros and Cons of Implied Volatility
- Assists in calculating the prices of options contracts
- Helps investors better understand a stock’s price and strategize better
- Puts a number on market sentiment for individual underlying stocks
- IV is not static, so it will be different from one day to the next and is not reliable
- Stocks can and do blow past the IV range after big announcements, so could present a risk for beginners
- Does not give an indication of the direction a stock’s price will go
Why Is Implied Volatility Important?
IV, as we’ve mentioned, is a critical part of most pricing models for stock options. While it is always changing, this sentiment of how volatile a stock might be providing a good opportunity for investors.
You might see charts comparing historical IV (which is slightly different from implied volatility) and actual volatility, and there will certainly be some differences and outliers.
However, IV is still used because it consistently proves to be relatively accurate to the actual price movements.
Do Day Traders Pay Attention to Implied Volatility?
Day traders pay attention to several different indicators that are similar to IV, though they might be watching an IV index that relates to a specific contract expiration date.
So, if a stock is showing a 25% IV, the actual IV for, say, the September 15 expiration would be quite a bit lower based on how close we are now to September 15.
Bottom Line: What Is Implied Volatility?
IV is somewhat complicated since it brings up several years of probability and statistics math. You probably wanted nothing more to do with it.
However, IV is very important to investors, especially those who spend more time in the options markets.
Even though it isn’t a crystal ball, it provides investors a thermometer of a particular stock to understand how far the market expects the stock’s price to move.