One of the most common mistakes investors make, when transitioning from stock to options trading, is that they fail to consider the role that implied volatility has on the price of an option.
This is another dimension in options trading which makes options more powerful… and complex. This is a big shift from stock trading – when you buy shares of a stock, the only thing that determines your profit or loss will be the change in the underlying stock price…that’s it… plain and simple.
However, the price of an option is a function of several factors that include: the price of the underlying stock, the risk-free interest rate, the implied volatility, the stock dividend, the strike price and the time to expiration. By plugging these inputs into an option-pricing calculator utilizing the Black-Scholes Formula or similar methodology, we get a theoretical value for of the option.
The investor could have gotten the timing wrong or misjudged the implied volatility…or maybe a combination of the two. Remember, options are wasting assets, an option is either going to expire worthless or in-the-money… there is no in between.
With that said, it’s typically the misunderstanding of implied volatility that causes options traders to lose the most money in the beginning of their journey.
Forgetting implied volatility is dangerous! It best describes if options are relatively cheap or relatively expensive as well as the future outlook of volatility on the underlying.
Let’s say you have a bullish view on a fictional company, XYZ Corp. XYZ Corp is trading at $100 a share and you believe that it will be trading higher over the next 3-4 weeks.
Now, the simplest way to make this trade is to buy a call options… not to say this is the best approach, likely far from it… but the easiest. Remember whenever you buy an option, you’re long volatility. That is, if option volatility rises you’ll benefit, however, if it declines you’ll suffer.
Whenever you buy an option, you’re long volatility. That is, if option volatility rises you’ll benefit, however, if it declines you’ll suffer.
What’s the problem with just having a directional opinion, without taking consideration on the implied volatility?
Well, you don’t know if the option you’re buying is relatively cheap or relatively expensive.
For example, let’s say you’re interested in XYZ corp’s options that expire in 30 days and you decide to buy the at-the-money ($100 strike) call options.
- At a 25% implied volatility, the call options have a value of $2.86
- At a 35% implied volatility, the call options have a value of $4.00
- At a 60% implied volatility, the call options have a value of $6.86
As you can see, the implied volatility plays a major factor on how options are priced. With that said, does it make sense to buy anyone of these call options listed above?
Implied volatility needs to be compared to something. For example, let’s say you consumed 2,500 calories yesterday. It means nothing unless you put it into context. If you typically consume 2,000 calories a day, than we can say, you consumed more calories than you normally do.
Going back to our XYZ Corp example, if we knew that the average 30-day at-the-money implied volatility over the last year was 20%, then, in this case, without further information, one could argue that all three options listed above are relatively expensive and in fact may be a better candidate to sell rather than buy.
So what causes shifts in implied volatility?
First, let’s get a better grasp on what implied volatility is. You see, the basic options pricing model assumes that volatility is constant. However, volatility shifts, it moves between highs and lows, eventually reverting to the mean. Implied volatility is the market’s current view of how much the stock is expected to move over the given timeframe.
In addition, implied volatility varies amongst option strike price as well as expiration period.
Implied volatility can fluctuate for a number of reasons.
Fear, Greed, and Uncertainty
Fear and greed are the most powerful emotions in trading and the most powerful to influence option implied volatility. Uncertainty ahead of an event is an excellent example. During an earnings release, stocks tend to move a lot more than usual… this makes sense because new information about the companies previous quarter as well as their guidance for the future is announced.
The potential for a larger-than-usual move will increase the implied volatility of the options. Traders will be bidding up the price of options, hence, making options more expensive. In the opposite direction, those who own stock may be looking to buy puts to hedge their stock position, even at higher prices.
Supply and Demand
The interaction between buyers and sellers causes shifts in implied volatility. For example, a large trader can come in and buy several thousand contracts of an option that normally trades a few hundred contracts a day. Since there are two sides of a transaction, the market maker is now short those options, hence, they are short implied volatility. At times they might buy stock to be “delta neutral” or reduce their directional risk, which further increases volume on the underlying.
Option volatility can rise on uncertainty. It can also rise, based on supply and demand factors; in addition to the actual price volatility seen in an underlying stock.
No matter how much the market maker hedges, they are still short implied volatility. To justify adding more volatility risk, they’ll raise their prices, the bid/ask price will increase; hence, options will become more expensive.
The majority of funds out there are long the stock market. During periods of low volatility, they are not overly concerned with hedging. However, if the market were to have a quick spike lower…traders might jump in and start buying put protection.
Now, these traders are not thinking about whether implied volatility is cheap or expensive…they don’t care…they just want to be hedged. This constant pressure to buy puts drives the implied volatility higher and makes the options more expensive.
On the flip side, periods of uncertainty, fear, and greed don’t last forever. For example, the implied volatility is sucked out of options after an earnings release. Eventually, implied volatility will revert back to its average or lower.
Another example, when stocks are hyped up, speculators tend to come in and start buying options. The hype surrounding the stock can cause the volatility in the options to explode. However, once the euphoria is over, that volatility comes in hard.
You see, with options, we can be a lot more flexible; unlike traditional stock investments, where we need a stock to go either up or down to make money.
Working with Brutus
That’s why using OptionAutomator’s Brutus Options Screener is so helpful. Through its assistance, you’ll be able to find high probability setups that fit your trading criteria, allowing you to stack the edge in your favor. Of course, this is all done without spending countless hours in front of your computer screen.
I hope this post has increased your understanding of implied volatility and how implied volatility is critical to successful options trading. Many traders fear implied volatility when they first transition to options trading, but I’m confident you’ll soon view it as core to the edge options provide over traditional stock investing.
- The price of an option is a function of several factors.
- The problem with having a directional opinion without considering implied volatility is that you don't know if you are buying expensive or cheap.
- Implied volatility plays a major role in how options are priced.
- Implied volatility can fluctuate for a number of reasons including fear, greed and uncertainty, supply and demand, insurance, and speculation.