Importance of Implied Volatility in Options Trading
Implied Volatility is one of the important factors which affect the prices of options. Having a clear idea about Implied Volatility will help you to earn a good reward from your option trades. Today we will take a look at what Implied Volatility is and how you can use it to your advantage.
Option premium:
All of us know that when we trade options we are actually trading the option premium, and are actually betting on how the option premium will move in the future.
There are 5 factors which determine what the option will be. These are:
- Price of the underlying asset: This is the actual price of the underlying in the spot market. When the underlying asset is traded in the underline market, its price goes up and down causing the option premiums to also move.
- Strike price: This is the strike price of the option in which you have traded. The strike price does not change as long as you are in the trade.
- Implied Volatility: This is the volatility of the underlying market. This is a statistical measure which tells how different will be the actual returns from the market will be different from the returns that we expect.
- Time to expiry: This is a time left between the present day to the day on which the option will expire.
- Rate of interest: This is the cost of borrowing. If you are trading in the option with borrowed money then you need to factor in the rate of interest which you will be paying to the lender.
We cannot calculate the value of the premium unless we have knowledge of all these factors.
How Implied Volatility affects option premium:
Consider one example. I want to start and options trade and when I look at the market at 10:00 am, I find the following:
| Factors | 10:00 am |
|---|---|
| Price of the underlying asset | 5000 |
| Strike price | 5000 |
| Time to expiry | 30 Days |
| Volatility | 20% |
| Rate of interest | 0% |
The premium that is being quoted in the market for this option is Rs. 120.
After 5 minutes when I check the premium again, I see that it has suddenly changed to Rs. 115, but the underlying has not made any movement.
| Factors | 10:00 am | 10:05 am |
|---|---|---|
| Price of the underlying asset | 5000 | 5000 |
| Strike price | 5000 | 5000 |
| Time to expiry | 30 Days | 30 Days |
| Volatility | 20% | ?? |
| Rate of interest | 0% | 0% |
| Premium | 120 | 115 |
As you can see, nothing has changed in the markets but still, the premium has changed. So what has caused this to happen? Yes, you guessed it right. It indeed is market volatility.
A change in market volatility can cause the option premium to change significantly even when there is no change in the other factors affecting option premium. Hence volatility is extremely important for every options trader. It can change the profit and loss profile of the options that you are holding. Hence you have to constantly follow the volatility of the market to stay safe from any possible losses arising out of a change in it.
Change in volatility causes the spot price to change too!
Volatility not only has an effect on option premiums but it also causes the spot prices to move. An increase in volatility will cause the spot prices to move faster and a decrease in volatility will cause it to move slowly.
The direction of movement here is not given by volatility. It will only tell you only how fast the movement will happen. Due to the effect that volatility has on spot prices, we always will have to keep an eye on it.
Consider this situation:
| Open | High | Low | Range | |
|---|---|---|---|---|
| Spot Price | 5000 | 5050 | 4950 | 2% |
| Volatility | 20% | 22% | 18% | 40% |
As you can see, the spot price has moved from 4950 to 5050 on a given day. This is a movement of just 2%.
However, on the same day, the volatility has moved in the range of 18 % to 22% which is 40%. This is a huge movement which you need to manage wisely.
Hence, if you trade in options by keeping an eye on the spot price movement only then it can create huge problems for you. Since volatility is the guiding factor it is important that you track it very closely so that you don’t end up getting some unexpected surprises.
At Finideas, we conduct several exciting courses which will teach you not only how to manage volatility but also how you can use it to your advantage. Let us know if you need any further information on volatility so that we can help you to trade better.