Managing Your Risk with Option Implied Volatility
Implied volatility (IV) is the market's expected volatility of a stock, backed out of current option prices. It helps manage risk because it tells you how expensive options are: high IV means rich premiums (favoring option sellers, with larger expected moves), and low IV means cheap premiums (favoring buyers). Traders combine IV with the option Greeks, the VIX, and volatility skew to choose strategies and size positions. This article explains each concept.
What is Implied Volatility?
Implied Volatility (IV) refers to the volatility that is built into a stock option’s price. It is calculated mathematically from the current market price of an option and the inputs of an option pricing model. This can be used to measure the expected movement of the underlying security against the price of the option.
The most commonly-used option pricing model is the Black-Scholes Model. It requires data inputs such as: the current price of the underlying asset, the strike price of the option, the time to expiration of the option, the risk-free rate, the current implied volatility of the underlying, and the dividend rate of the underlying asset.
What is the Volatility Premium?
The volatility premium is the gap between an option's implied volatility and the realized (historical) volatility of the underlying. When implied volatility runs above realized volatility, options are priced richly relative to how much the stock has actually moved. (The amount an option trades above its intrinsic value is called extrinsic or time value.) It’s important to understand the concept of the Volatility Premium and how it can be used to your advantage when trading options.
What are Option Greeks?
Option Greeks are the risk metrics that are used to measure the sensitivity of the price of an option to changes in certain variables. The most commonly used Option Greeks are Delta, Gamma, Theta, Vega and Rho. Delta measures the rate of change of an option’s price relative to the underlying security’s price. Gamma measures the rate of change of Delta as the underlying security’s price changes. Theta measures the time decay of an option’s value as time passes.
Vega measures the sensitivity of an option’s price to changes in the implied volatility of the underlying security. Lastly, Rho measures the sensitivity of an option’s price to changes in the interest rate. Understanding Option Greeks and how they interact with each other can help you better understand the price dynamics of an option.
What is the VIX Index?
The Cboe VIX Index measures the 30-day implied volatility of S&P 500 index options. It is also known as the “Fear Index” and is often used as a gauge of investor sentiment. The VIX Index can be used to measure the overall level of implied volatility in the markets. This can be a useful tool for investors who want to get an idea of how volatile the markets may be over the short-term or long-term.
What is Volatility Skew?
Volatility skew is the difference in implied volatility across strike prices for the same expiration. In stock index options, lower-strike puts usually carry higher implied volatility than higher strikes, a downward-sloping shape called a volatility smirk. When implied volatility is higher at both low and high strikes than at the money, the shape is called a volatility smile.
What are Implied Volatility Spreads?
Implied Volatility Spreads are option trades that involve buying and selling options with different strike prices but the same expiration date. They are used to take advantage of the volatility skew and can be used as a way to increase your potential returns. They can also be used as a way to hedge against the downside risk of a position as well.
How Can I Use Implied Volatility to Manage My Risk?
Implied volatility is an important concept to understand when trading options. It can help you understand the current sentiment of the market and how the underlying security could move over the short-term or long-term. It can also be used to help you manage your risks when trading options. You can use implied volatility to select which strategies to employ for a particular underlying stock or ETF.
By understanding implied volatility and the option Greeks, you can choose strategies whose risk matches your view, for example selling premium when IV is high or buying options when IV is low.
Here are some templates that you can use to create your own models
Relevant blogs that you can read to learn more about the topic
Take the Guesswork Out of Options Trading with a Call Option Calculator
