Volatility: High, Low, Implied and Historical

Implied Volatility might be the most critical aspect of options trading – because of how it impacts option prices.

Implied Volatility (IV) is a metric used in options trading to estimate the future volatility of the underlying asset based on the current price of the options. It reflects the market’s forecast of a likely movement in an asset’s price. Essentially, IV provides an insight into how the market perceives the future volatility of the asset, and it significantly influences the pricing of options contracts.

Here’s are a few ways that IV and market price are linked.

  1. Higher Implied Volatility: If the IV is high, it suggests that the market expects significant price movement (up or down) of the underlying asset in the future. This increased uncertainty or risk is priced into the options, making them more expensive. Options traders are willing to pay more for the potential of larger moves.
  2. Lower Implied Volatility: Conversely, if the IV is low, the market expects less movement in the price of the underlying asset. With lower expected risk or movement, options are priced cheaper, as the potential for dramatic price changes is less.
  3. Direction Neutral: It’s important to note that IV does not indicate the direction of the price movement (whether up or down); it only reflects the magnitude of expected price movement.

Let’s break down the 3 terms found in the title of this article.

Implied: A forward looking statement about the future. Because the Apple call 45 days until expiration is trading for $3.15 implies something about what the market things about Apple stock over the next 45 days.

  • If the call was trading for $5.15 the market would be implying that it expects a larger movement from Apple stock.
  • If the call was trading for $1.15 the market would be implying that it expects a smaller movement from Apple stock.

Historical: A statement about the past and what actually happened. How much did Apple stock actually move over the previous 45 days?

  • This is also often called realized volatility.
  • It is calculated by the following steps:
    • Get daily prices of the stock
    • Calculate the daily returns ((today – yesterday)/yesterday)
    • Calculate the standard deviation of these daily returns
    • Annualize it (Annualized Volatility = SD of Daily Returns * Sqrt(252))

For the engineers, here is how it might look in Python:

daily_prices = np.array([100, 102, 101, 103, 104, 105, 107, 106, 108, 109, 110, 
                         111, 113, 114, 115, 116, 118, 117, 119, 120, 121])

def calculate_historical_volatility(daily_prices):

    # Calculate daily returns
    daily_returns = np.diff(daily_prices) / daily_prices[:-1]
    # Calculate the standard deviation of daily returns
    std_dev_daily_returns = np.std(daily_returns)
    # Annualize the volatility
    annualized_volatility = std_dev_daily_returns * np.sqrt(252) * 100  # Multiplied by 100 to get percentage
    return annualized_volatility

Volatility: How much does the price of the underlying fluctuate?

Now we can combine these terms to get a better understanding of what they represent.

Implied Volatility: (From now looking forward) How is the market pricing the expected move over the next X number of days?

Historical Volatility: (From now looking backward) How much has the underlying actually moved during the previous X number of days?

If you compare these two values, HV and IV, you can determine if the cost of the option may be cheap or expensive – in terms of the price of volatility. For example:

For stock ABC, the stock has barely moved much up or down in the past 45 days.

  • The HV of ABC is .15
  • The IV of ABC is .30

This means that the market is currently willing to pay 2x for the future move relative to the realized move over the same period.

If history repeats itself over the next 45 days, and the IV that was priced at .30 materializes into HV that is realized at .15 then the options were over priced – and selling them would have been profitable.

For example, what is the chance that a coin lands on heads or tails? 50%.

  • If you were paid $.90 for a $1 bet on tails but $1.10 for a $1 bet on heads – which one would you choose to bet on? Between heads and tails, which is over priced and which is under priced?
  • The “seller” of this game is IMPLYING that heads is less likely to occur (higher payout) and tails is more likely to occur (lower payout).
  • But you know about coin flips. You know that in the past over billions of attempts, heads and tails are very close to a perfect 50/50.
  • So what do you do? You bet on heads – it has a positive expected value over time. You avoid tails – it has a negative expected value.
  • Partially correct and a profitable strategy, but you are leaving money on the table.
  • If you are allowed or able, you would ideally be selling bets on tails which would earn you $1 and then making bets on heads spending that same $1.

In this example, you are “selling the expensive bet” and “buying the cheap bet” based on two factors:

  • HV: the historical performance of coin flips
  • IV: the market pricing of future coin flips

As an option seller, your alpha is the relationship between the two of these.

The future is unknown – and a cheap option may become expensive and vise versa. You really do not have control over the future outcome – so instead you want to focus on how other traders are pricing that future outcome and then make an informed decision on what to do today given that information. Here are a few ways to do that:

1. Volatility Trading Opportunities

  • High IV: Options with high IV are more expensive due to the anticipated volatility. This scenario might be suitable for selling strategies (like writing options) because you can receive higher premiums. However, it’s also riskier as the underlying asset is expected to have larger price swings. When risk is high do you want to be selling or buying insurance?
  • Low IV: Options with low IV are cheaper, which might be more favorable for buying strategies. When you expect volatility to increase from unusually low levels, buying options could be advantageous as the potential for profit increases if the market moves significantly. When risk is low do you want to be selling or buying insurance?

2. Comparing Historical Volatility (HV) with IV

  • IV higher than HV: If the IV of an option is higher than the historical volatility of the underlying asset, the option might be overpriced, suggesting a potential sell opportunity.
  • IV lower than HV: If the IV is lower than the HV, the option might be underpriced, indicating a buying opportunity.

3. Volatility Smiles and Skews

  • Analyzing the pattern of IV across different strike prices and expiration dates (known as volatility smiles and skews) can indicate market expectations and potential moves – across dates or prices points. These patterns can help traders identify mispricings or develop strategies that exploit the differential in IV across options.
  • In theory, calls and puts would all be proportionately priced “fairly” across the chain based on Black Scholes. In reality, market participants move these prices according to their expectations. This “skew” can be exploited.

4. Hedging

  • IV can inform hedging strategies. For instance, in a high IV environment, traders might close their existing hedges, sell puts, or otherwise “buy the dip” (adding positive delta). Cash in your insurance plan when sufficient damaged has occurred.
  • In low IV environments, traders might open new hedges – while they are relatively cheap – just to protect their core positions from future unexpected increases in volatility.

5. Straddle and Strangle Strategies

  • In uncertain markets, when you expect volatility but are unsure about the direction, strategies like straddles or strangles (which involve buying/selling both a call and a put option) can be profitable. High or Low IV can indicate the right moment to enter such trades because when IV is high the theory would be you want to be a seller and when IV is low you want to be a buyer.

6. Implied Volatility Rank (IVR) and Implied Volatility Percentile (IVP)

  • IVR and IVP provide context on how current IV compares to past IV levels over a specific period. These metrics can help traders assess whether IV is relatively high or low, guiding strategy selection.
  • Implied Volatility Rank (IVR) Implied Volatility Rank (IVR) offers a way to understand the current implied volatility of an option in comparison to its historical implied volatility range over a specific period, typically 52 weeks. IVR is expressed as a percentage, where a higher percentage indicates that the current IV is at the upper end of its 52-week range, suggesting that the options are relatively expensive. Conversely, a lower IVR suggests that the current IV is at the lower end of its historical range, indicating potentially cheaper options. IVR is calculated by taking the difference between the current IV and the 52-week low IV, divided by the difference between the 52-week high IV and the 52-week low IV. This metric helps traders assess whether an option’s premium is high or low in a historical context, aiding in decision-making for buying or selling options based on perceived value. Implied Volatility Percentile (IVP) Implied Volatility Percentile (IVP), on the other hand, measures how many days in the past year (or another specified period) the implied volatility has been lower than the current IV. It’s also presented as a percentage. A high IVP (e.g., 90%) means that the current IV is higher than it has been for 90% of the past year, indicating that the option’s premium is relatively high most of the time. A low IVP indicates that the current IV is only higher than a smaller percentage of its past values, suggesting that the option’s premium is relatively low. Unlike IVR, which compares the current IV against the highest and lowest IVs in a range, IVP provides insight into the distribution of IV levels over a specified period, offering a different perspective on the current IV’s rarity or commonality. This can be particularly useful for identifying extremes in market sentiment or potential mean-reversion opportunities in options pricing.

7. Earnings Announcements and Event-Driven Trades

  • IV tends to increase before known events (like earnings announcements), as these events can cause significant price movements. As a result, people bid up the price of insurance (calls and puts) leading up to the binary event.
  • Regardless of the resulting direction, the Implied Volatility of these option contracts almost always decreases after the event. This is known as “vol crush” or other similar terms. This happens because people close (sell) all of their insurance policies (options) after the event occurs – the thing they were insuring against is over.

Strategies for High IV and Low IV Environments:

Strategies for Low IV Environments

In low implied volatility (IV) environments, option premiums are generally cheaper, making strategies that benefit from an increase in IV or a move in the underlying asset more attractive.

  1. Long Calls/Puts: Buying calls or puts is a straightforward strategy in low IV conditions. Traders might purchase options when premiums are relatively cheap, anticipating a move in the underlying stock that will increase the option’s value.
  2. Debit Spreads: Constructing a debit spread involves buying an option (call or put) and simultaneously selling another option of the same type with a different strike price. This strategy benefits from directional moves and can be more cost-effective in low IV environments, as the purchased option is cheaper, and the sold option reduces the overall cost of the trade.
  3. Calendar Spreads: A calendar spread involves buying an option with a longer expiration and selling an option with the same strike price but a shorter expiration. This strategy aims to profit from the time decay of the short-term option at a faster rate than the long-term option, and it can be particularly effective when IV is expected to rise, as the increase in IV will increase the value of the longer-dated option.

Strategies for High IV Environments

In high IV environments, option premiums are more expensive, reflecting higher expected volatility. Strategies in such conditions often aim to benefit from the eventual decrease in IV or capitalize on the high premium levels.

  1. Short Calls/Puts (Naked or Covered): Selling calls or puts can be more lucrative in high IV conditions because the premiums received are higher. A covered call involves holding the underlying asset and selling call options against it, while naked puts involve selling puts without holding the underlying asset, aiming to profit from the premium decay as IV decreases.
  2. Credit Spreads: A credit spread involves selling an option (either a call or a put) and buying another option of the same type with a different strike price, but with the option sold being closer to the current market price. This strategy results in a net credit to the trader’s account, with the hope that both options will expire worthless, allowing the trader to keep the premium. High IV enhances the premium received, making this strategy more appealing.
  3. Iron Condors: An iron condor is a more complex strategy that combines a put credit spread and a call credit spread, essentially betting that the underlying asset will remain within a certain range until expiration. The strategy benefits from the decay of option premiums and is particularly attractive in high IV environments because the premiums received are higher, potentially offering greater returns if the underlying stays within the expected range.

Each of these strategies leverages the current IV environment to match the trader’s market outlook, risk tolerance, and objective, whether it’s capitalizing on premium decay, directional moves, or range-bound trading.

Putting it All Together:

  • Volatility – future and historical – is important to track when trading options and it can be used to inform your strategy selection.
  • The relationship between HV and IV can be exploited by selling expensive and buying cheap options.
  • Events – like earnings and others like FOMC releases – drive up implied volatility and therefore price. This explains “vol crush” which occurs after the event is over.
  • There are quite a few different types of option strategies that are suited for high IV and low IV environments.

Do you have questions about how IV is used in options trading? Leave them in the comments below. If you found this content helpful please share it on social media and consider creating your free account on IntraAlpha.