The following article deals with implied volatility of options. First, we will learn the meaning of implied volatility. After this, we explain its importance for option pricing and investment strategies.
Before going deeper, let’s remember the generalized meaning of volatility.
Volatility in Finance
What is Implied Volatility?
Why is the Implied Volatility so important for Options Trading?
Implied volatility is one of the most important influencers of option pricing, the comparison of options and options trading:
The implied vol is the only non-observable parameter in the options pricing formula.
There’s a direct relationship between the implied volatility and the premium. When an option has a higher IV, we have to pay a higher price for the option. Likewise, a higher price implies a higher IV if the other parameters stay equal. This effect is due to the pricing model as we will explain later.
There’s a correlation with the market opinion. The option’s current price reflects the expected future volatility.
Conclusion: Implied vol makes options comparable and is a measure of value.
One of the key abilities of options traders is the discovery of the most valuable options. The question is how we can compare different options and choose the best investment.
Here, implied vol can be a better tool than the option’s price. When it comes to evaluating stock options or fx options, the price of the underlying asset or fx pair and the implied volatility are the two main factors.
The price of the underlying asset is the same for all options but they have different implied volatilities. Therefore, the options’ relative value can be compared by their implied vol.
This comparison is of such importance that professional traders often quote the value of an option in terms of its implied vol rather than its premium. In the end, we are interested in comparing and finding the best investment.
Why is the Implied Volatility needed for Option Pricing?
Why does option pricing depend on implied volatility? Suppose, the premium could be calculated without the IV. Then traders would only buy options before major news or elections because a price spike would be expected. The options market wouldn’t work.
That’s why the implied volatility is much higher before major News announcements, political insecurity (elections, etc.) or during fear in the markets.
Other Things to know
The implied volatility is no predictor for the direction.
Even when we know the value of expected volatility, it’s no indicator for the direction of the next movement. High volatility expects a larger price swing to happen but it could happen in both directions.
The implied volatility depends on the pricing model and its parameters.
Options for the same asset or Forex pair will have different implied volatilities when their strike prices and time to expiration are different. Thus, the IV is non-constant among options of different pricing models and different parameter values.