Gauging Price Movement With Implied Volatility

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Nov 24, 2021
Behailu Tekletsadik

Implied volatility (IV) is one of the essential metrics for options price analysis, but it is often misunderstood since it is never set in stone. Advanced options traders often trade contracts solely on volatility, but novice and amateur traders usually avoid trading volatility because it seems like an abstract metric on the surface.

Thankfully, we are here to describe what IV is and how you can use it in your daily trading strategies. Regardless of whether you want to trade volatility directly or simply add it to your models, the information in this post will serve as a simple foundation for a critical aspect of options trading.

Once you better understand IV and how it impacts options trading strategies, you will be able to leverage the Lantern IV screener functionality within the app.

How Options Prices Change

Implied volatility is the most influential factor on an option’s premium when intrinsic value and time value are considered. Let’s say you are trading a $70 call option for XYZ corporation, whose stock is currently trading at $85. This contract’s intrinsic value is $15 (Share price — Strike price).

Our example above indicates that the contract is in the money (ITM) and could be profitable if exercised or sold today. However, time value is constantly eroding the contract’s intrinsic value as it approaches its expiration date. Implied volatility measures the market’s sentiment at a given moment on a contract and carries the heaviest weight on an option’s time value.

Implied Volatility Can Indicate Future Price Movements

The markets move on information and data flow, and IV helps traders gauge where expectations sit at a given moment on security. Stocks that exceed expectations, such as a blowout quarterly earnings, will immediately reframe the market’s perception of that stock and send IV through the roof.

Another way we can describe IV’s impact on an option’s price is the current supply and demand for the contracts. When a stock beats earnings expectations, demand for call options usually increases, resulting in higher premiums from the higher IV. Conversely, if a stock routinely misses expectations and has no market interest, IV will drop, referred to as IV crush.

Before you go and look for options with the highest IV, remember that it can drop suddenly, resulting in a loss for that contract, even if the underlying stock continues to rise. Additionally, IV is used as a metric to forecast changes in price, but it does not guarantee the direction the change will be.

Bearish

Traders often see the highest implied volatility during bearish markets because traders feel that prices will begin declining in the near to mid-future. The CBOE Volatility Index (VIX) is one of the more famous volatility indices on the market. It can be an excellent quick reference to see how the entire stock market views volatility at a given moment. However, it will trickle down in strong bull markets, so traders should keep their eye on it.

Bullish

When markets are good and the sentiment is high, IV is often suppressed because many traders believe that prices will remain high, and there is not much competition for “exciting stocks.” However, when volatility reaches an extreme top or bottom, you should be aware that it may reverse and move back within one standard deviation of its average level for that option.

Considerations for Options Traders

Trading options with IV adds another dimension to your trading strategy, especially if you are trading American-style options (which most people do in the US). These options can be exercised at any time, whereas traders can only exercise European-style options on their expiration date.

Binomial Vs. Black-Scholes

The Black-Scholes model is one of the most famous options pricing tools because it includes many variables, including strike price and time to expiration. However, beware if you are basing your models off of it because it cannot give an accurate price for American options because there is only room for one expiration date, whereas there are theoretically as many expiration dates as the life of the contract.

Suppose you want to take early exercising into account. In that case, you may want to try the binomial model because it depicts a graphical path that an option’s price could take given changes in volatility, but it is still not perfect. These models can serve as solid reference material, but each trade will be unique to its contract.

Historical Volatility

Many theorists write off historical volatility since it will never be duplicated precisely, which is a shame. Taking historical volatility into account can provide a wealth of data on how different stocks or industries generally respond to IV shifts.

How to Screen for Implied Volatility

Hopefully, you have a better understanding of Implied Volatilitity’s power in options pricing. The Lantern App has an IV screener that will enable you to track and measure IV on any options contract you choose.

For example, suppose you want to enter a volatility trade. In that case, you can sort through the top IV companies in the app or search our directory for companies you believe will soon experience a surge in volatility due to macro or company-specific events such as a clinical trial. If volatility is high and you are bearish on the company, you can buy puts or sell calls to capitalize on the potential reversal. A more robust strategy for spread traders would be to open an Iron Condor with lower potential returns than a naked strategy and lower loss potential.


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