Implied Volatility in plain English

[OddTrader]

http://en.wikipedia.org/wiki/Implied_volatility

"
Implied volatility as a price

Another way to look at implied volatility is to think of it as a price, not as a measure of future stock moves. In this view it simply is a more convenient way to communicate option prices than currency. Prices are different in nature from statistical quantities: one can estimate volatility of future underlying returns using any of a large number of estimation methods; however, the number one gets is not a price. A price requires two counterparties, a buyer and a seller. Prices are determined by supply and demand. Statistical estimates depend on the time-series and the mathematical structure of the model used. It is a mistake to confuse a price, which implies a transaction, with the result of a statistical estimation, which is merely what comes out of a calculation. Implied volatilities are prices: they have been derived from actual transactions. Seen in this light, it should not be surprising that implied volatilities might not conform to what a particular statistical model would predict.

"

Quote from optionsforum:

Hi guys I'm trying to wrap my head around IV. Still a newbie in the options world.

Hope someone can explain this as easy as possible in plain english
For example..

lets say xyz is trading at $100 today on Sept 18. The call option for $102 Oct 18 is selling for $3 and the implied volatility is 60%.

What is the 60% IV telling me?

thanks in advance!

 

[trilogic]

Quote from sle:

Here is an intuitive explanation of implied volatility, without even mentioning Black/Sholes or stochastic calculus. You just need to understand the option payoff and how option price changes with the underlying.

The thought process is actually pretty straight forward:
(a) in order to lock in option value in a manner independent of the underlying asset direction, you need to neutralize the directional exposure of the option (that is, hedge delta).
(b) if you neutralise the directional exposure on regular basis, you total P&L (at expiration) will depend on day-to-day changes in underlying and on the initial price of the option.
(c) so, initial price of the option should be a function of some-kind of expectation of cumulative day-to-day changes.

Understanding how that translates into BS or any other model is secondary, people have traded and delta-hedged options before BS (though BS did make the thought process much more intuitive).

long run

do options traders who delta hedge "on a regular basis" make better returns than those who use options as a tool just to buy and sell the "market" without regard to "if" the option are over / under valued ? What do good option traders returns look like relative to a regular long/short fund ?


If one understand the model inefficiencies would there not be free money laying all around the markets ?

 

[stock777]

Quote from newwurldmn:

If you understood black scholes you would be impressed with how elegant the formula is and how well it mimics real life.

r u sure real life doesnt mimic bs?

 

[stock777]

what I dont get is how the market makers are able to make money on 1 cent spreads in active options. must be the fees.

 

[StarDust9182]

Quote from sle:

What do you think comes first, option price or expected volatility of the stock? Let me ask you differently - if you have to buy or sell an option that does not have a listed market, how would you approach it?

How about using mark-to-fantasy like some of the listed derivatives today?

A stock's price can also be looked at as a kind of implied volatility limit as theta approaches zero.

I like to think of IV as a measure of the market's perceived risk at any given point.

 

[trilogic]

Quote from StarDust9182:

How about using mark-to-fantasy like some of the listed derivatives today?

A stock's price can also be looked at as a kind of implied volatility limit as theta approaches zero.

I like to think of IV as a measure of the market's perceived risk at any given point.

Everything is "mispriced" that's why underlying, then the options move ? Sometimes the skew will be leaning then at some random point during the day or next couple days the "options" get it right

 

[newwurldmn]

Quote from stock777:

r u sure real life doesnt mimic bs?

The forces that move stocks are far larger than the forces that care about black scholes.

 

[justrading]

Quote from newwurldmn:

The forces that move stocks are far larger than the forces that care about black scholes.

So true!

Everyone starting out trading options should think about this.

 

[Georgi90]

Quote from justrading:

So true!

Everyone starting out trading options should think about this.

what you care which force is greater. I trade options and I am more interested in the black scholes than only the stock movement itself.

 

[justrading]

Quote from Georgi90:

what you care which force is greater. I trade options and I am more interested in the black scholes than only the stock movement itself.

I trade options too bubba.

Gets a bit old when you have technically perfect positions on that go down the toilet when Uncle Ben opens his gap, so yes, I do care what the underlying does.