Implied Volatility

Implied Volatility Formula (IV) Explained

The implied volatility formula is a predominant factor in an options price movement. It shows you how the market views where volatility is heading in the future. You use this to look forward to gauging volatility. IV doesn’t forecast the direction an option is going. There’s raw implied volatility and also IV Rank and IV percentile. Rank and percentile are more accurate than raw IV. 

The implied volatility formula (IV) is found by taking the price of an option and putting it into a pricing model called the Black-Scholes. Volatility measures the magnitude of change. It will always be different because options contracts have different strike prices and expiration dates. Think of it as a price and not the direction. The stock will move because of supply and demand. 

Several components make up options contracts, but IV is crucial. It is an important part of learning options trading. Many components make up the options’ prices—for example, the current stock price, the strike price, the time value, and implied volatility.

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 want to check the future volatility of the airline ticket, look at its IV.

Implied Volatility Formula Algebra

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.

What is IV Crush, you ask? As the stock gets closer and closer to earnings, the market (the market makers) will start pricing in an “implied” move for the stock price as earnings approach.

They’re looking at that earnings date as a catalyst that needs to be priced in when selling options on the market (selling to buyers). This means IV goes up as we get closer to earnings; thus, the option’s price goes up.

It is a big pump, and after earnings, there is usually a huge drop in IV, which drops the option’s price. Knowing this beforehand, you can profit from IV Crush like the pros.

Implied Volatility Formula Example

Intrinsic Value Calculator Example

This is an example of an options chain for $MSFT using the TOS platform. The columns can be customized to show extrinsic value, intrinsic value, strike prices, in the money, at the money, and out of the money.

It also shows the Options Greeks, such as gamma, delta, vega, and theta.

Stability

As a trader, the implied volatility formula lets you see how stable the market views options and contract prices. A higher IV 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 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, 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 you wouldn’t make a profit if you paid $3.50 for the option.

Lower IV 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. 

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.

It is one of the deciding factors in the price of an option. Selling options is a great trading strategy to learn to use IV to your benefit.

The higher the IV, the higher the premium you will pay. Take into consideration that the IV 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 the price could go in either direction.

Buying a high-volatility call doesn’t mean the price will shoot up. It could end up going down. By comparison, the opposite is true. 

Implied Volatility

Implied Volatility Formula and Calculator Factors

The definition of volatility is the liability to change rapidly and unpredictably. The market is unpredictable. Anything can change the direction of the market. Supply and demand affect the implied volatility formula.

The more demand a stock has, the higher the IV 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.

IV% also goes up when an event is on the horizon. Stay, earnings, or an FDA approval. As you approach these events, IV will ramp up., After an event, IV will “Crush” and drop.

Knowing how to play IV properly is a great way to trade options. When %IV is high, people will sell options and collect a high premium. Anything over 40 or 50% IV is a good target to start looking at selling premium. 

IV will be less if there’s a large supply but less of a demand. The option is considered less risky. Similarly, you’ll find the premium price is cheaper. 

Limitations of Implied Volatility Formula

While the implied volatility formula does not have specific problems, there are some limitations and considerations when using it.

The formula for implied volatility has a limitation. It assumes that the future price movements of the underlying asset will follow a specific probability distribution, usually the log-normal distribution. However, price movements may only sometimes follow the expected distribution during extreme market conditions or events.

Another consideration is that implied volatility is based on the market prices of options contracts. Therefore, supply and demand, market sentiment, and other factors influence it. This means that it may not always accurately reflect the true volatility expectations of the underlying asset.

Additionally, implied volatility estimates future volatility and may not accurately predict price movements. It is worth noting that alternative volatility measures, such as historical volatility, can be used to calculate volatility. Historical volatility can provide different insights and may be useful in some cases.

In conclusion, while the implied volatility formula is widely used and provides valuable information, it has limitations and should be used cautiously. Hence, it is essential to consider other factors, like the Greeks, to make well-informed decisions. Many seasoned traders rely on option Greeks to evaluate whether or not they should make the trade.

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Risks of Implied Volatility

Implied volatility in options trading carries certain risks that traders should know. Below are some potential dangers from implied volatility in options:

1. Price Swings

As mentioned above, implied volatility is the market’s expectation of price movements in the underlying asset. When implied volatility is high, options prices can significantly increase or decrease. Hence resulting in bigger gains or losses. As a result, traders should be prepared for increased volatility and manage risk accordingly.

When implied volatility is higher, options premiums tend to be more expensive, as there is a greater expectation of price swings in the underlying asset. Conversely, when implied volatility is lower, options premiums tend to be cheaper, as there is a lower expectation of significant price movements.

2. Premium Decay

Implied volatility influences the price of options. As an option approaches expiration, the effect of implied volatility on the option premium may become less significant. Interestingly enough, higher implied volatility at the time of purchase can erode the option’s value over time, even if the underlying price remains relatively stable. Unfortunately, this decay can result in losses for option holders.

3. Unexpected Changes

Implied volatility is not static and can change unexpectedly due to economic events, earnings announcements, or market sentiment shifts. Sharp increases in implied volatility can significantly impact option prices and result in unexpected losses. Traders need to actively monitor and manage their positions to reduce the risks associated with changes in implied volatility. For further information on managing risk, check out our blog post here

4. Limited Control

Traders have limited control over implied volatility as the market determines it. While historical volatility can help estimate future implied volatility, it does not provide precise predictions. Implied volatility can deviate from historical levels, leading to potential differences between expected and actual option pricing.

To navigate these risks, traders must implement risk management strategies such as setting stop-loss orders, diversifying their options, and using hedging techniques to help mitigate potential losses. 

Before trading options:

  • Do your research.
  • Understand the risks associated with implied volatility.
  • Seek help from experienced professionals like Bullish Bears.

This will undoubtedly help you make informed decisions and avoid potential pitfalls. We offer a whole suite of options trading courses to get you started in your options trading journey. Without a doubt, this will help you make informed decisions and avoid potential pitfalls. 

Key Takeaways

  • Implied volatility refers to a measure of expected future price volatility of an underlying asset, such as a stock, that options traders use
  • When implied volatility is higher, options premiums tend to be more expensive, as there is a greater expectation of price swings in the underlying asset.
  • Traders cannot directly control implied volatility as the market determines it.
  • Implied volatility is a tool investors and traders use to evaluate the desirability of options contracts.
  • However, implied volatility is a forward-looking metric that cannot predict an option’s direction.

Final Thoughts: Implied Volatility Formula

Avoid buying options without studying IV properly. Many pro traders SELL options going into earnings because they know the stock is priced to move X amount of dollars.

Selling options as a call or put spread can be extremely profitable AFTER earnings and after the IV drops and smashes the option’s price. 

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.

If you need more help, take our options trading course.

Frequently Asked Questions

High implied volatility means the market forecasts potential large swings for a particular stock. Low IV means smaller price swings. Credit spreads are a great strategy to use for high implied volatility.

Volatility measures the data of a security over a specific time. It's one of the most critical factors that make up an options contract.

Here's how to calculate volatility manually: 

  1. Find the stock's past pricing
  2. Calculate the average price (mean) of the stock's past pricing
  3. Find the difference between each stock's price in the set and the average price.
  4. Square the differences of step 3.
  5. Sum the squared differences.
  6. Divide the squared differences by the total prices in the set (find variance).
  7. Calculate the square root of the number obtained in the previous step.

This means that implied volatility traded below current levels in 90% of total trading days over the past 52 weeks. Furthermore, implied volatility was higher than the current level in only 10% of total trading days over the past 52 weeks.

An implied volatility of 20% means the options market estimates that a one-standard-deviation return in the underlying (positive or negative) in the next year will be 20% of the current price. In a (log)normal distribution, about 2/3 of the instances fall within one standard deviation, leaving the remaining 1/3 of returns outside that range.

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