The implied volatility formula is an important part of options trading. There are many different components that make up the options price. For example, the current stock price, the strike price, time value, and implied volatility.
Implied volatility shows you how the market views where volatility is heading in the future. You use this to look forward in gauging volatility. Implied volatility doesn’t forecast the direction an option is going.
Implied volatility will always be different because options contracts have different strike prices and expiration dates. Think of implied volatility as a price and not the direction. The stock will move because of supply and demand. You need buyers and sellers.
IMPLIED VOLATILITY FORMULA
Volatility measures the magnitude of change. For instance, the price of airfare is volatile. The price of an airline ticket can change quickly and without warning. So, if you wanted to check the future volatility of the airline ticket, look at it’s implied volatility.
The implied volatility formula is found by taking the price of an option and putting it into a pricing model called the Black-Scholes. This solves for volatility. It’s like doing algebra all over again. Did you ever think you would use that algebra class in the real world? Nevertheless break out the implied volatility calculator!
IMPLIED VOLATILITY FORMULA – WHY IS IT USEFUL?
The implied volatility formula allows you as a trader to see how stable the market views options contract prices. Higher implied volatility means the stock’s price is less stable.
Less stability means more risk. If you’re buying an option with a high implied volatility, you’re saying that there’s a higher chance the option goes into the money. You’ll make more money.
In the money means your option is worth something. In other words, you can sell it. For example, you bought an XYZ call option at $12 and it’s now trading at $15. You can sell it for a $3 gain.
Although, being in the money doesn’t always mean you’ll profit. For example, your gain was $3 but if you paid $3.50 for the option then you wouldn’t make a profit. Lower implied volatility means less risk. If you buy at a lower implied volatility you are saying you do not think there’s a big chance the price will move. So you do not mind getting paid less to sell.
Ichimoku is a very popular technical analysis indicator to use when trading options. Check out our Ichimoku Cloud post to learn more.
IMPLIED VOLATILITY FORMULA – VOLATILITY AND PRICE
The implied volatility formula can be hard to understand because of the math involved. The most important thing to know is the relationship between volatility and price. Implied volatility is one of the deciding factors of the price of an option.
The higher the implied volatility, the higher the premium you are going to pay. Take into consideration that the implied volatility is only an estimation of future prices. There’s no guarantee that the price will reach what’s implied.
The implied volatility formula isn’t going to predict the trend of the stock. To put it another way, it’s not where the price will go. High volatility predicts a large price swing but price could go in either direction. Buying a call with high volatility doesn’t mean that the price will shoot up. It could end up going down. By comparison the opposite is true.
IMPLIED VOLATILITY FORMULA – WHAT FACTORS AFFECT IT?
The definition for volatility is the liability to change rapidly and unpredictably. The market is unpredictable. Anything can change the direction of the market. Supply and demand affects the implied volatility formula.
The more of a demand a stock has, the higher the implied volatility will be. Demand causes the price of the option to rise. The premium rises because the option is considered more risky. Of course the opposite is also true.
If there’s a large supply but less of a demand, then implied volatility is going to be less. The option is considered less risky. Similarly, you’ll find the premium price is cheaper. You need the volume.
Another factor to consider is the expiration date. The more time value you have the more implied volatility there is. However, the shorter the option time value the less risky the option.
Use the implied volatility formula to your advantage. If you’re buying a call or put give yourself time. Let implied volatility work for you.
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