The fact, when a stock doesn’t trade options, then this cannot be calculated. IV reflects what the market perceives about future price fluctuations based purely on supply and demand in the options market.
Market makers and traders rely on models to determine the “correct” IV for a stock, often engaging in arbitrage to exploit perceived discrepancies.
Ultimately, implied volatility serves as an estimate of how much the market anticipates the stock price to move over a given period.
Calculating Implied Volatility: A Mathematical Perspective
Implied volatility is not directly observed; rather, it is deduced from the use of option pricing models such as the Black-Scholes model.
Here is a simple process:
- Input Known Variables: Some of the known variables fed into the model include the underlying stock price, the strike price, time to expiration, risk-free rate, and option premium.
- Solve for IV: The model then solves for implied volatility, where the equation is balanced so that the theoretical option price matches with the market price.
This process requires rearranging the Black-Scholes formula in order to solve for IV, which requires iterative calculations instead of straightforward algebra.
Many brokerage firms use proprietary models to calculate IV, which means slight variations exist between platforms.
How Brokerage Firms Use Proprietary Models
Brokerage firms develop proprietary models to determine IV and other option Greeks like Delta and Theta.
Models give traders key metrics that could be crucial for decision-making. While Deltas may differ slightly between Fidelity, Schwab, or Ally brokers, they are largely alike because they use similar approaches.
Brokerage firms also derive IV from the market prices of options contracts. They take known inputs into their pricing models and come up with implied volatility levels for specific expirations and strike prices, thus giving the trader accurate and actionable information.
Implied Volatility in Option Pricing
Implied volatility significantly influences the price of an option.
Higher IV generally leads to more expensive options because it indicates greater expected price movement, increasing the probability of the option finishing in-the-money.
Conversely, lower IV results in cheaper options, reflecting subdued market expectations for volatility.
This relationship explains why IV is sometimes called the “fear gauge” in options trading.
When fear or uncertainty increases in the market, IV usually increases, and so do option prices.
Standard Procedures for Computing Implied Volatility
The standard procedure for computing IV is to use the at-the-money (ATM) option contract for the desired expiration.
Here’s how:
- Choose an Expiration: Choose the particular expiration date for which you wish to compute IV.
- Identify the ATM Option: Find the option contract that has a strike price closest to the current stock price.
- Calculate IV: Use either the Black-Scholes model or proprietary model to derive the implied volatility for that contract.
For instance, if you want to calculate IV for January’s third Friday expiration, you would use the ATM option from that expiration to derive the IV.
This method ensures consistency and accuracy across calculations.
Practical Implications for Traders
Implied volatility must be understood and utilized by the options trader for success.
Here are some practical takeaways:
- IV and Option Prices: Traders should watch IV levels to determine if options are overpriced or underpriced. High IV can signal expensive options, while low IV may indicate a bargain.
- IV and Market Sentiment: High IVs often occur when the market is anxious or has several drivers that are likely to propel the price, such as earnings or geopolitical events.
- Tactics in High IV: One tactic is selling options as the higher premium is easily taken advantage of.
- Tactics in Low IV: Buying options will become more desirable as the costs are cheaper.
Implied Volatility by Expirations
IV is relative to the expiration and strike price of an option contract.
For example, January expiration options may have a different IV than February options because people have different expectations in the market about what’s going to happen.
As such, evaluation of IV should be against the backdrop of the strategy and timeline chosen.
Conclusion
It’s a backbone of options trading.
It reveals so much in terms of the sentiment of the market and the expectations within it.
With knowledge on how IV is derived, how it is incorporated into pricing, and practical applications, the trader makes more informed decisions.
In a market characterized by shifts in its sentiments and finer calibration in trading, understanding implied volatility is very crucial.