what is implied volatility?

In financial markets, we all understand volatility as something very unstable and very bad. In the case of equities, stocks that have volatile earnings tend to get low P/E valuations in the market. Interestingly, the situation is exactly the opposite concerning options. In the case of options, the higher is the volatility, the better it is for the value of call and put options. But a lot of us do wonder about implied volatility meaning or IV as they are called. IV is unique to options and we will look at that in detail later. First, let us understand what is implied volatility in general and what is implied volatility in options?

What have implied volatility options?

Implied volatility options are different from historical volatility. Many traders tend to mistakenly confuse historical volatility with implied volatility. That is not correct. By definition, volatility is simply the amount the stock price fluctuates, without regard for direction. Now let us turn to historical volatility and implied volatility.

Historical volatility is the standard deviation that you calculate from the historical prices of the stock. That is what is history and that is what has already happened. It tells you how volatile the stock has been in the past. It tells you nothing about the future. On the other hand, implied volatility is what is implied in the options prices. Options prices reflect expectations and therefore implied volatility is about the future and not about the past. That is why from a trader's perspective or a market perspective, it is implied volatility that has more relevance compared to historical volatility.

Let us get a little deeper with an illustration. For example, if a stock is at Rs.1,000 at the beginning of the month and Rs. 1,002 at the end of the month, it does not reflect a stock with low volatility. The stock could have gone as low as Rs.840 and as high as Rs.1280 during the month before closing at Rs.1,002. Hence volatility is not about point-to-point prices. They may be the same but still, the stock could have gone through a lot of volatility in between.

Just bear in mind that all that we have spoken about here in this illustration is about historical volatility. That is a good illustration of the past but tells little about what will happen in the future. For that we go into implied volatility, an important and rather less understood concept about options valuations and options pricing.

Implied volatility is not based on the historical pricing data of the stock at all. On the other hand, implied volatility tells you what the market is “implying” volatility of the stock will be in the future. This implication is gauged by the movements in the market price of options. Of course, here the assumption is that options tend to reflect risk and volatility fairly, which is a good assumption in a liquid and broad options market like India. Like historical volatility, eve implied volatility is expressed on an annualized basis. But implied volatility is analytically and actionably of more interest to option traders than historical volatility as it is forward-looking.

Based on expectations and analysis of the market, the option prices will keep shifting. For example, if the stock prices are going to move up or down, then the option is first seen in option prices and so it has an impact on option implied volatility. That is how implied volatility gets predictive value for stock prices.

Implied volatility is a dynamic figure that changes on a real-time basis based on activity in the options market. Remember, the Indian options market is very liquid, especially on the Nifty options. What does it mean practically? When implied volatility increases, the price of options will increase. So, when implied volatility increases after a trade has been executed, it is favorable for the option buyer and negative for the seller. Similarly, if the implied volatility decreases after your trade are executed, the price of options decreases. That is favorable for the option seller but negative for the option buyer. That is observing option IV is important for the buyer and the seller of the option.

How is implied volatility expressed in the real market?

Implied volatility is expressed as a percentage of the stock price. To that extent from here on, the interpretation is the same as standard deviation. That means; like in any normal distribution, the price should be in the range of 1-IV on 68.26% occasions, 2-IV on 95.45% occasions, and 3-IV on 99.73% occasions. That means a stock that is priced at Rs.100 with 18% IV has a 68.23% probability of remaining between Rs.82 and Rs.119 through the year. You can make similar calculations for 2IV and 3IV also.

How is the price of a derivative determined?

Let us look at the pricing of futures based. Futures are priced based on the cost of carrying. The futures price is normally the spot price plus the cost of carrying. Futures are also priced by arbitrage opportunities. Once the futures or spot price cerates arbitrage opportunities, the futures price converge towards normalizing arbitrage.

Options priced based on volatility. Normally, the higher the volatility, the highest the options price, and the lower the volatility, the lower is the options price. Here when we talk of volatility, we are referring to implied volatility or IV.

What are derivatives?

In finance, a derivative is a contract that derives its value from the performance of an underlying entity. That underlying can be a stock, a bond, a currency, an index, a commodity, etc. The price of the derivative contract is determined based on the price of the spot. Derivatives are broad of four classes viz. forwards, futures, options, and swaps.