Implied Volatility

[wayneL]

Quote from isoroi:

Can someone explain to me how to interpret IV?

I tried to do research on the web to get a better grasp of this concept, but it always seems to confuse me.

The higher the iv, the higher the option premiums will be in relationship to their expiration. Is this correct?

I also read that there is numerous methods of calculating the IV, and that there is no standardized method of calculating it.

I guess what annoys the piss out of me is that I can't figure out why I even should care about the IV. Shouldn't I be able to see the bloated option premium in relation to the stock price and derrive the same information I would by looking at the IV?

My take:

Implied volatility is the markets estimate of forward volatility, in other words it is a perception of risk.

So what is this IV figure that is quoted? It is the measure of one standard deviation of price movement, annualized.

So let's take a figure of 30% IV. This figure says that the market thinks that there is a ~68% chance that the share price will be within 30% in one years time.

But that's not much good to us when the option expires in 6 weeks time. We can use this figure to convert this annualized figure into figure that reflects the markets expectations of price movement in that time frame.

The quick and dirty equation is:

IV, divided by 16, times the square root of the number of trading days remaining till expiry

Lets say IV is 32 and there is 36 trading days till expiry. (this will make the calcs easy)

So: 32/16*sqrt36
=12%

So now we can see that the market thinks there is a ~68% chance that the share price will be within 12% of todays price in 36 trading days. (and ~95% chance of being within 24% of todays price)

Bigger % is peception of greater probability of price moves, i.e. greater risk, therefore higher option price.

Cheers

 

[jllm03]

One thing I have noticed on a stock option that has a High IV. The Theoretical Value is always a high delta from the actual option price.
OptionsXpress that I trade with has a Pricer that will give you all the Greeks and Theoretical Value on each option.
I use this to look for bloated options to sell in a spread.

 

[isoroi]

Quote from MTE:

No way it was yesterday's close example. That call has been trading below 0.35 since October.

In any case, here's an example for you.

Say you got two stocks, both at the same price. The equivalent calls are trading at 1.20 and at 2.65.

Which one is more bloated? The first one or the second one?

And what if I told you that the second stock is twice as volatile as the first! Would your answer be still the same?

Finally, what if I told that the first stock's current IV is twice the IV it has exhibited in the past?

Ok, it was a bad example, but an example nonetheless.

Using your example, assuming they are the same strike and expiration, I would guess that the 2.65 was more bloated. I'd also make the same assumption that the 2.65 was more volatile. Am I correct?

I can understand the relationship of the 1st stock's IV in comparison with previous months. But what value does the IV have with other stocks?

 

[isoroi]

Maybe this will help out.

This is data from optionstoolbox for AMD sorted by IV.

1 AMD 21.24 AMDAW Jan '07 17.50 C 4.21 2.21 1 0.50
2 AMD 21.24 AMDDW Apr '07 17.50 C 4.95 5.70 4 0.48
3 AMD 21.24 AMDAT Jan '07 19.00 C 3.02 3.70 1 0.48
4 AMD 21.24 AMDAD Jan '07 20.00 C 2.35 5.23 1 0.47
5 AMD 21.24 AMDAE Jan '07 25.00 C 0.47 2.24 1 0.46

The last column is the IV.

 

[isoroi]

So, based upon WayneL's response...

and this option

AMD 21.24 AMDAW Jan '07 17.50 C 4.21 2.21 1 0.50

50/16*sqrt2=4.419%

So, the market thinks there is a 50% chance that the share price will be within 4.4% of today's price in 2 days?

I have this feeling I'm completely wrong here.

 

[MTE]

Quote from isoroi:

Ok, it was a bad example, but an example nonetheless.

Using your example, assuming they are the same strike and expiration, I would guess that the 2.65 was more bloated. I'd also make the same assumption that the 2.65 was more volatile. Am I correct?

I can understand the relationship of the 1st stock's IV in comparison with previous months. But what value does the IV have with other stocks?

Yes, the assumption is that they are the same strike and the same expiry. You cannot say that the 2.65 is more bloated, as it is proportional to higher IV that the second stock is trading at. Just by looking at the two premiums you cannot say which one is more bloated. Well, you could if you watched the options of the same stock day in day out for a couple of years as you would have developed a "feel" for the premium, but otherwise you can't tell.

I'm not sure I understand your last question, but the idea is that option premiums are proportional to the IV so, once, again you cannot say whether an option's premium is bloated or not just by looking at the premium.

Let's put it this way, you can look at past levels of implied volatility and see where does the current level is in relation to past levels. This is a quick way to see whether options are relatively expensive or cheap (i.e. relative to historical option prices).

 

[MTE]

Quote from isoroi:

So, based upon WayneL's response...

and this option

AMD 21.24 AMDAW Jan '07 17.50 C 4.21 2.21 1 0.50

50/16*sqrt2=4.419%

So, the market thinks there is a 50% chance that the share price will be within 4.4% of today's price in 2 days?

I have this feeling I'm completely wrong here.

This is a Jan option so it has 36 days to expiry.

 

[isoroi]

Quote from MTE:

Yes, the assumption is that they are the same strike and the same expiry. You cannot say that the 2.65 is more bloated, as it is proportional to higher IV that the second stock is trading at. Just by looking at the two premiums you cannot say which one is more bloated. Well, you could if you watched the options of the same stock day in day out for a couple of years as you would have developed a "feel" for the premium, but otherwise you can't tell.

I'm not sure I understand your last question, but the idea is that option premiums are proportional to the IV so, once, again you cannot say whether an option's premium is bloated or not just by looking at the premium.

Let's put it this way, you can look at past levels of implied volatility and see where does the current level is in relation to past levels. This is a quick way to see whether options are relatively expensive or cheap (i.e. relative to historical option prices).

So, two options with the same price, same volume, same everything, but with different option premiums. You can't look at the two and make the assumption based on premium which is bloated. And that's all based on previous pricing? And by looking at the IV of the two options, you can tell which one has a greater probability of moving? Does it also indicate which direction or just the expected volatility?

 

[isoroi]

Quote from MTE:

This is a Jan option so it has 36 days to expiry.

Oops.

50/16*sqrt36=18.75%

So, the market thinks there is a 50% chance that the share price will be within 18.75% of today's price in 36 days.

Is this right?

 

[MTE]

Quote from isoroi:

So, two options with the same price, same volume, same everything, but with different option premiums. You can't look at the two and make the assumption based on premium which is bloated. And that's all based on previous pricing? And by looking at the IV of the two options, you can tell which one has a greater probability of moving? Does it also indicate which direction or just the expected volatility?

Greater probability of moving translates into higher premium - it's all proportional, there's no free lunch.

Implied volatility indicates only expected volatility (i.e. range of prices) not direction!

I don't think you can get away with a shortcut 101 crash course in implied volatility. You need to understand the pricing, you need to understand all the details. Why? Cause there are more ways to lose money in options than you can think of, so you always need to understand why you made/lost money on a particular trade so you can make adjustment accordingly.