How is options implied volatility for a stock determined?

[Luis Cruz]

Hi,

For any give stock, in TWS (and on any other broker) there is a reported options historical volatility and an options implied volatility. I know the historical volatility is the annualized standard deviation of the stock. But how is the implied volatility determined?

I am aware that the implied volatility is the volatility the market expects in the future. But how far in the future? i.e is it the implied volatility using options that will expire in one year? Is it the implied volatility using options of expiry of one month? Is it determined using at the money or in the money options?

I don't need to know the mathematical model used (if it's based on black scholes or not), I basically just would like to know some general information about how the stock's IV is determined. i.e What options with what strike prices and expiry dates are used to determine the IV.

Basically I would like to know the following... After I know there are cheap options based on low implied volatility percentile, how should I proceed to buy the option? Since there are many options with different IVs, which option should I buy? The one with the closest IV compared to the one of the stock? Or what?

The thing I am struggling the most right now is in regards to my last question. I know there are plenty of factors that will affect my decision on what option I should buy. On my case, I am planning on using a delta-neutral and positive vega strategy, possibly with a long straddle. Therefore, I am looking for the stocks with the most cheapest options (historically) and my broker gives me a number (the IV) and then I determine the IV percentile based on where the IV has been historically.

I am also combining this strategy with a sentiment indicator, so when I determine there is a stock with cheap options AND that I predict there will be volatility in the future with the sentiment indicator I enter a trade. At this point I am unsure on what to do. Should I look for longer term options which are more sensitive to vega? Should I look for options that have IVs close to the value I got from the broker (the reported IV for the stock? etc etc...

Do you have any suggestions about this? If you know an article or something that I could read about this, that'd be great. If not, any type of guidance would be greatly appreciated!


Thanks in advance.

 

[stepandfetchit]

I believe it "should" be derived from the 30 Day IV in method similar to that of the CBOE VIX white paper. However, for example, currently the VIX is 13.36, yet the IV for SPX from TOS is reported as 14.10%, so the difference implies either time lags with the computations, or my "theory" is flawed!

Regarding how to use this IV information: I think, most people using this information are relying on the tendency of IV to revert to a mean for the specific underlying. So, if the IV is higher than some threshold, it is more likely that the IV will decrease, so this could be a better time to "sell premium". The converse may not be precisely true, as the time expectation for an increase in IV, is less obvious. <-- my opinion, take with grain of salt.

 

[Luis Cruz]

I believe it "should" be derived from the 30 Day IV in method similar to that of the CBOE VIX white paper. However, for example, currently the VIX is 13.36, yet the IV for SPX from TOS is reported as 14.10%, so the difference implies either time lags with the computations, or my "theory" is flawed!

Interesting. I believe it should be the V30 as well... In regards to my last question though, what do you suggest my approach should be after determining there is a stock with a historically low IV? Should I buy the options with the longest time expiry I could get? Or should I buy the one closest to 30-days (because the IV is probably based on a 30-day window)? Choosing an option with a short-expiration such as 30 days frightens me though.

 

[stepandfetchit]

Interesting. I believe it should be the V30 as well... In regards to my last question though, what do you suggest my approach should be after determining there is a stock with a historically low IV? Should I buy the options with the longest time expiry I could get? Or should I buy the one closest to 30-days (because the IV is probably based on a 30-day window)? Choosing an option with a short-expiration such as 30 days frightens me though.

Luis: If you find a profitable answer to that question, please let me know as well! I would think, that if you have skills in directional trading, then coupling that with a low IV for position entry, could be a big plus. I know of no way to predict an increase in IV, other than upcoming earnings, or Yellen meetings or other known upcoming events. Examination of IV charts tend to confirm a decay function that may be tradable, but not visa-versa. Your interest seems to be trying to anticipate an increase in IV, which is not my strong suit (to say the least).

Part of your last question relates to the IV value being 30 days, and trying to correlate that with the time frame of your option choice. That 30 day number is probably a very good and fairly stable reference point. To consider different time frames (less than and/or greater than 30 Days), look at the option series IV (TOS lists one for each option series) that is computed similar to that 30 Day algorithm, but for that specific DTE. Typically they will be in Contango, but if in Backwardation, you may want to re-think your new position as this Backwardation will not persist very long, and you want to be on the correct side of this IV swing. (not stated very well, but I hope you understand what I'm trying to clarifiy)

 

[Luis Cruz]

Luis: If you find a profitable answer to that question, please let me know as well! I would think, that if you have skills in directional trading, then coupling that with a low IV for position entry, could be a big plus. I know of no way to predict an increase in IV, other than upcoming earnings, or Yellen meetings or other known upcoming events.

What about basing your strategy on mean reversion? IV tends to be mean-reverting. Most of the times you can look at the chart and see if there's a low point historically that will guarantee and increase in probability of IV reversion.

 

[Martinghoul]

Hi,

For any give stock, in TWS (and on any other broker) there is a reported options historical volatility and an options implied volatility. I know the historical volatility is the annualized standard deviation of the stock. But how is the implied volatility determined?

I am aware that the implied volatility is the volatility the market expects in the future. But how far in the future? i.e is it the implied volatility using options that will expire in one year? Is it the implied volatility using options of expiry of one month? Is it determined using at the money or in the money options?

I don't need to know the mathematical model used (if it's based on black scholes or not), I basically just would like to know some general information about how the stock's IV is determined. i.e What options with what strike prices and expiry dates are used to determine the IV.

Basically I would like to know the following... After I know there are cheap options based on low implied volatility percentile, how should I proceed to buy the option? Since there are many options with different IVs, which option should I buy? The one with the closest IV compared to the one of the stock? Or what?

The thing I am struggling the most right now is in regards to my last question. I know there are plenty of factors that will affect my decision on what option I should buy. On my case, I am planning on using a delta-neutral and positive vega strategy, possibly with a long straddle. Therefore, I am looking for the stocks with the most cheapest options (historically) and my broker gives me a number (the IV) and then I determine the IV percentile based on where the IV has been historically.

I am also combining this strategy with a sentiment indicator, so when I determine there is a stock with cheap options AND that I predict there will be volatility in the future with the sentiment indicator I enter a trade. At this point I am unsure on what to do. Should I look for longer term options which are more sensitive to vega? Should I look for options that have IVs close to the value I got from the broker (the reported IV for the stock? etc etc...

Do you have any suggestions about this? If you know an article or something that I could read about this, that'd be great. If not, any type of guidance would be greatly appreciated!


Thanks in advance.

There is no such thing really as "the stock's IV". IV is a quantity which is calculated for a particular option, based on its price.

Therefore, you're seeing some quantity that TWS labels "option IV". To understand what that quantity is, you need to ask TWS.

 

[Luis Cruz]

There is no such thing really as "the stock's IV". IV is a quantity which is calculated for a particular option, based on its price.

Therefore, you're seeing some quantity that TWS labels "option IV". To understand what that quantity is, you need to ask TWS.

Yes, actually there is such thing. And a lot of traders actually use it as an indicator, to see if the options of that stock are expensive or cheap. And I did ask TWS, this is what they said:

"The 30-day volatility is the at-market volatility estimated for a maturity thirty calendar days forward of the current trading day. It is based on option prices from two consecutive expiration months. The first expiration month is that which has at least eight calendar days to run. The implied volatility is estimated for the eight options on the four closest to market strikes in each expiry. The implied volatilities are fit to a parabola as a function of the strike price for each expiry. The at-the-market implied volatility for an expiry is then taken to be the value of the fit parabola at the expected future price for the expiry. A linear interpolation (or extrapolation, as required) of the 30-day variance based on the squares of the at-market volatilities is performed. V30 is then the square root of the estimated variance. If there is no first expiration month with less than sixty calendar days to run, we do not calculate a V30."

 

[stepandfetchit]

What about basing your strategy on mean reversion? IV tends to be mean-reverting. Most of the times you can look at the chart and see if there's a low point historically that will guarantee and increase in probability of IV reversion.

My experience with IV mean reversion downward has been fairly reliable. My experience with IV mean reversion upward, not so much, so I have no current trading plans for expectation of a low IV increasing. (My experience in this area is very limited, so you may wish to inquire of some with successful strategies for profiting from increases in IV.)

 

[Martinghoul]

Yes, actually there is such thing. And a lot of traders actually use it as an indicator, to see if the options of that stock are expensive or cheap. And I did ask TWS, this is what they said:

"The 30-day volatility is the at-market volatility estimated for a maturity thirty calendar days forward of the current trading day. It is based on option prices from two consecutive expiration months. The first expiration month is that which has at least eight calendar days to run. The implied volatility is estimated for the eight options on the four closest to market strikes in each expiry. The implied volatilities are fit to a parabola as a function of the strike price for each expiry. The at-the-market implied volatility for an expiry is then taken to be the value of the fit parabola at the expected future price for the expiry. A linear interpolation (or extrapolation, as required) of the 30-day variance based on the squares of the at-market volatilities is performed. V30 is then the square root of the estimated variance. If there is no first expiration month with less than sixty calendar days to run, we do not calculate a V30."

Brilliant, there you have it then...

 

[cvds16]

there is no such the as THE implied volatility ... it changes with every options strike price and/or duration and yes you need to use the math to get it right ... when you find something peculiar there is often a good reason for it like skew ...
overal it's supply and demand in options in a certain month on a certain stock that determine the implied vol. But like I said there is also skew to take into account.