Implied volatility 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 in 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.
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How Do You Calculate the Implied Volatility Formula of a Stock?
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. IV will always be different because options contracts have different strike prices and expiration dates. Think of IV as a price and not the direction. The stock will move because of supply and demand.
There are several components that make up options contracts but IV is a very important factor. The implied volatility formula is an important part when you learn 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.
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.
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? Well, as a stock is getting closer and closer to earnings, the market (the market makers) will start pricing in an “implied” move for the price of the stock 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 and thus, the price of the option goes up.
It is a big pump, and after earnings, there is usually a huge drop in IV, and this drops the price of the option. If you know about this ahead of time, you can profit from IV Crush like the pros do.
Stability
The implied volatility formula allows you as a trader to see how stable the market views options contract prices. 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 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 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.
Implied volatility is one of the deciding factors of 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 are going to 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 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.
Is High Implied Volatility (IV) Good?
High implied volatility that the market forecasts potential large swings for a particular stock. Low IV means smaller price swings. Credit spreads are a great strategy to uses for high implied volatility.
Factors
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 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 with trading options in general. When %IV is high, people will sell options and collect high premium. Anything over 40 or 50% IV is a good target to start looking at selling premium.
If there’s a large supply but less of a demand, then IV is going to be less. The option is considered less risky. Similarly, you’ll find the premium price is cheaper.
IV Crush
Avoid buying options without studying IV properly. Lots of pro traders SELL options going into earnings because they know that the stock is priced in to move X amount of dollars.
And selling options as a call or put spread can be extremely profitable AFTER earnings and after the IV drops and smashes the price of 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.
If you need more help, take our options trading course.
