WHAT IS IMPLIED VOLATILITY AND WHY IMPLIED VOLATILITY IS IMPORTANT FOR OPTION TRADING ?
Most of traders ignore the implied volatility in trading but this is very useful tools. Implied volatility (IV) is the most useful mathematical tools in stock market of the option greeks. Implied volatility can be used to adjust your risk control and trigger trades.
Implied volatility changes as investor sentiment changes in the market and can be very sensitive to the overall market environment. It can forecast the market direction and make trading decisions.
Implied volatility as measure of relative value
The implied volatility of an option is a more useful measure of the option's relative value than its price. The reason is that the price of an option depends most directly on the price of its underlying asset. Implied volatility is so important that options are often quoted in terms of volatility rather than price, particularly between professional traders. In short in a single and simple line i would like to say that Implied volatility is simply a amount the stock price will fluctuate either side.
Example
A call option is trading at Rs.1.50 with the underlying trading at 78.05. The implied volatility of the option is determined to be 18.0%. After few days, the option price is trading at 2.10 with the underlying at Rs.79.5., yielding an implied volatility of 17.2%. It means that the price option of the call of underlying may fall and rise 17.2%. Even though the option's price is higher at the second measurement, it is still considered cheaper based on volatility. The reason is that the underlying needed to hedge the call option can be sold for a higher price.
Implied volatility reflects what traders “thinking” about the potential for the underlying stock or index.
Implied volatility will rise when traders are becoming very fearful. Same implied volatility will fall when investors are very bullish. This matters to option traders because an increase in implied volatility causes a rise in option premiums. But that is bad for option buyers but can be good for sellers. When implied volatility is falling and traders are becoming more bullish, option prices fall and being a call buyer may be a better alternative than being a put seller.
Implied volatility is a dynamic figure that changes based on activity in the options marketplace. Usually, when implied volatility increases, the price of options will increase as well, assuming all other things remain constant. So when implied volatility increases after a trade has been placed, it’s good for the option owner and bad for the option seller.
Same if implied volatility decreases after your trade is placed, the price of options usually decreases. That’s good if you’re an option seller and bad if you’re an option owner.
For example, imagine stock XYZ is trading at Rs.70, and the implied volatility of an option contract is 15%. This implies there is a consensus in the market that a one standard deviation move will be happen either side plus or minus 10 (since of the Rs.70 stock price equals Rs.10).
Traders thinks that there’s a 68% chance that XYZ will be settle between Rs.60 and Rs 80.
Most of traders ignore the implied volatility in trading but this is very useful tools. Implied volatility (IV) is the most useful mathematical tools in stock market of the option greeks. Implied volatility can be used to adjust your risk control and trigger trades.
Implied volatility changes as investor sentiment changes in the market and can be very sensitive to the overall market environment. It can forecast the market direction and make trading decisions.
Implied volatility as measure of relative value
The implied volatility of an option is a more useful measure of the option's relative value than its price. The reason is that the price of an option depends most directly on the price of its underlying asset. Implied volatility is so important that options are often quoted in terms of volatility rather than price, particularly between professional traders. In short in a single and simple line i would like to say that Implied volatility is simply a amount the stock price will fluctuate either side.
Example
A call option is trading at Rs.1.50 with the underlying trading at 78.05. The implied volatility of the option is determined to be 18.0%. After few days, the option price is trading at 2.10 with the underlying at Rs.79.5., yielding an implied volatility of 17.2%. It means that the price option of the call of underlying may fall and rise 17.2%. Even though the option's price is higher at the second measurement, it is still considered cheaper based on volatility. The reason is that the underlying needed to hedge the call option can be sold for a higher price.
Implied volatility reflects what traders “thinking” about the potential for the underlying stock or index.
Implied volatility will rise when traders are becoming very fearful. Same implied volatility will fall when investors are very bullish. This matters to option traders because an increase in implied volatility causes a rise in option premiums. But that is bad for option buyers but can be good for sellers. When implied volatility is falling and traders are becoming more bullish, option prices fall and being a call buyer may be a better alternative than being a put seller.
Implied volatility is a dynamic figure that changes based on activity in the options marketplace. Usually, when implied volatility increases, the price of options will increase as well, assuming all other things remain constant. So when implied volatility increases after a trade has been placed, it’s good for the option owner and bad for the option seller.
Same if implied volatility decreases after your trade is placed, the price of options usually decreases. That’s good if you’re an option seller and bad if you’re an option owner.
For example, imagine stock XYZ is trading at Rs.70, and the implied volatility of an option contract is 15%. This implies there is a consensus in the market that a one standard deviation move will be happen either side plus or minus 10 (since of the Rs.70 stock price equals Rs.10).
Traders thinks that there’s a 68% chance that XYZ will be settle between Rs.60 and Rs 80.
