What is put call ratio and implied volatility?1.What is put call ratio? It is easy to define put call ratio, it is the ratio of total number of put options to call options. There are two types, volume based PCR and open interest PCR. Total trading volume is taken to calculate the Volume PCR and total open interest is taken in the case of open interest PCR.
2. What is implied volatility? Implied volatility of an option contract is defined as the volatility of underlying asset price, which is implied /indicated by the market price of that option. Simply, Nifty 5000 call option's implied volatility means the volatility of the price of nifty index, indicated by the price of 5000 call option. So Implied volatility is the relative rate at which price of the nifty/stock changes with reference to that particular strike price Different strikes will be having different implied volatility numbers. Implied volatility is a main part of option pricing. Premium of an option consist of intrinsic value and time value.
What is intrinsic value?
Simple, if Nifty is trading at 5000 and 4900 call costs 150 Rupees, then 5000- 4900 =100 is the intrinsic value and rest of 50 is the time value. When implied volatility is high, there is higher possibility for a good trend/ price movement. It can also be called as expected volatility till the contract expires. There will be increase in implied volatility, when market is expecting for something, like any economic event/ important results etc. hence it will also reflect in the price of option.
Means if 5000 call is trading at 150 Rs at 30 % implied volatility, When that "expectation is over" and guess Implied volatility comes down to 15 % , option price will fall to 75 RS (imagine there is no change in Nifty index price). Hence implied volatility is a very important factor in option pricing and option trader need to be cautious about changes in Implied volatility. Bear market will be having higher implied volatility than the bull market, because falling prices makes people more emotional than the rising price.
OTHER DEFINATION
The definition of Put-Call Ratio (PCR) is as follows:
The ratio of the volume of put options traded to the volume of call options traded, which is used as an indicator of investor sentiment (bullish or bearish).
1 group of thought says that a high PCR means more number of Puts have been written and markets should go ahead. Another school of thought says the converse.
Lets go by the data in hand for past 1 year.The market has bottomed when PCR was around 0.8-0.9 and topped when it was 1.2 or above.
I have marked in black the instances where the PCR was above 1.2. At this point of time, the market remains flat for a day or 2 by which time the PCR comes down to lower level or the market tanks.
1. Which option should you buy? with high iv or low iv?
2. how will you consider that iv is extreamly high or low?
While knowing the effect volatility has on option price behavior can help cushion against losses, it can also add a nice bonus to trades that are winning. The trick is to understand the price-volatility dynamic - the historical relationship between directional changes of the underlying and directional changes in volatility. Fortunately, this relationship in equity markets is easy to understand and quite reliable. (To lean more on price volatility, check out Price Volatility Vs. Leverage.)
The Price-Volatility Relationship
A price chart of the S&P CNX NIFTY and the implied volatility index (VIX) for options that trade on the S&P CNX NIFTY shows there is an inverse relationship. As Figure 1 demonstrates, when the price of the S&P CNX NIFTY (top plot) is moving lower, implied volatility (lower plot) is moving higher, and vice versa. (Charts are an essential tool for tracking the markets. Learn about the chart that many investors use to interpret volatility and place well-timed trades; read Range Bar Charts: A Different View Of The Markets.)
Figure 1: S&P CNX NIFTY daily price chart and implied volatility (VIX) daily price chart. Price and VIX move inversely. Buying calls at market bottoms, for example, amounts to paying very rich premiums (loaded with implied volatility) that can evaporate as market fears subside with market upturns. This often undermines call buyers' profit performance.
The Impacts of Price and Volatility Changes on Options
The table below summarizes the important dynamics of this relationship, indicating with "+" and "-" signs how movement in the underlying and associated movement in implied volatility (IV) each impacts the four types of outright positions. For example, there are two positions that have "+/+" in a particular condition, which means they experience positive impact from both price and volatility changes, making these positions ideal in that condition: Long puts are affected positively from a fall in S&P CNX NIFY but also from the corresponding rise in implied volatility, and short puts receive a positive impact from both price and volatility with a rise in the S&P CNX NIFTY corresponding to a fall in implied volatility. (Learn the effect volatility has on option prices. Check out The Price-Volatility Relationship: Avoiding Negative Surprises.)
Table below Impact of price and volatility changes on long and short option positions. A “+” mark indicates positive impact and a “-“ mark indicates a detrimental impact. Those marked with "+/+" indicate the ideal position for the given market condition.
But in the opposite to their "ideal" conditions, the long put and short put experience the worst possible combination of effects, marked by "-/-". The positions showing a mixed combination ("+/-" or "-/+") receive a mixed impact, meaning price movement and changes in implied volatility work in a contradictory fashion. Here is where you find your volatility surprises.
Remember from The Table that a long call suffers from a fall in implied volatility, even though it profits from a rise in price (indicated by "+/-"). AND table below shows that the VIX levels plunge as the market moves higher: Fear is abating, reflected in a declining VIX, leading to falling premium levels, even though rising prices is lifting call premium prices. Due to website address written on chart i am not posting chart here. you may see chart on website.
PRICE VILATILITY DYNAMIC PRICE VOLATILITY DYNAMIC
POSITION RISE IN NIFTY/FALL IN IV FALL IN NIFTY/ RISE IN IV
LONG CALLS +/- -/+
LONG PUTS -/- +/+
SHORT CALLS -/+ +/-
SHORT PUTS +/+ -/-
Long Calls at Market Bottoms Are "Expensive"
In the example above, the market-bottom call buyer ends up purchasing very "expensive" options that in effect have already priced-in an upward market move. The premium can decline dramatically due to the falling levels of implied volatility, counteracting the positive impact of a rise in price, leaving the unsuspecting call buyer miffed over why the price did not appreciate as anticipated.
The Bottom Line
Even if you correctly forecast a market rebound and attempt to profit by buying an option, you may not receive the profits you were expecting. The fall in implied volatility at market rebounds can cause negative surprises by counteracting the positive impact of a rise in price. On the other hand, buying puts at market tops has the potential to provide some positive surprises as falling prices push implied volatility levels higher, adding additional potential profit to a long put bought very "cheaply." Being aware of the price-volatility dynamic and its relation to your option position can significantly affect your trading performance.Using Implied Volatility to Determine Strategy
You've probably heard that you should buy undervalued options and sell overvalued options. While this process is not as easy as it sounds, it is a great methodology to follow when selecting an appropriate option strategy. Your ability to properly evaluate and forecast implied volatility will make the process of buying cheap options and selling expensive options that much easier.
When forecasting implied volatility, there are four things to consider:
Make sure you can determine whether implied volatility is high or low and whether it is rising or falling. Remember, as implied volatility increases, option premiums become more expensive. As implied volatility decreases, options become less expensive. As implied volatility reaches extreme highs or lows, it is likely to revert back to its mean.
If you come across options that yield expensive premiums due to high implied volatility, understand that there is a reason. Check the news to see what caused such high company expectations and high demand for the options. It is not uncommon to see implied volatility plateau ahead of earnings announcements, merger and acquisition rumors, product approvals and other news events. Because this is when a lot of price movement takes place, the demand to participate in such events will drive option prices price higher. Keep in mind that after the market-anticipated event occurs, implied volatility will collapse and revert back to its mean.
When you see options trading with high implied volatility levels, consider selling strategies. As option premiums become relatively expensive, they are less attractive to purchase and more desirable to sell. Such strategies include covered calls, naked puts, short straddles and credit spreads. By contrast, there will be times when you discover relatively cheap options, such as when implied volatility is trading at or near relative to historical lows. Many option investors use this opportunity to purchase long-dated options and look to hold them through a forecasted volatility increase.
When you discover options that are trading with low implied volatility levels, consider buying strategies. With relatively cheap time premiums, options are more attractive to purchase and less desirable to sell. Such strategies include buying calls, puts, long straddles and debit spreads.
Conclusion
In the process of selecting strategies, expiration months or strike price, you should gauge the impact that implied volatility has on these trading decisions to make better choices. You should also make use of a few simple volatility forecasting concepts. This knowledge can help you avoid buying overpriced options and avoid selling under priced ones.
This article is taken from www.nsetopper.com for educational purpose.
