DEFINITION
Implied volatility predicts how much a security's price might change within a specific time frame. It's commonly used to determine the pricing of options contracts.
Implied volatility measures how likely a stock will go higher or lower over a set time, typically until the options contract ends. For stock options, this period refers to the duration of the contract, until it expires.
Implied volatility is a predictive gauge that relies on how a stock is performing in the market and the demand and supply for that specific stock option. It basically shows how risky the market perceives that option to be.
Implied volatility doesn't forecast the direction a stock will move, but it estimates how much it might move in any direction. It helps traders assess both the potential risk and reward involved.
Implied volatility doesn't predict which direction a particular security will move, only how much it is likely to move in any direction. It gives traders a way to measure potential risk and reward.
If a stock is valued at ₹100 and has an implied volatility of 30%, it's expected that its price will usually be between ₹70 and ₹130 in the upcoming year. This ₹30 range on both sides is termed statistically as one standard deviation. Sometimes, the stock might move further, reaching two or even three standard deviations, expanding the range to ₹10 to ₹190. However, the probability of these wider movements decreases as you move away from the typical range.
When you're purchasing stock options with specific timeframes, the annual implied volatility (IV) might not provide precise information for a specific option's contract period. To adjust this IV to match the duration of an option contract on that stock, you need to divide the yearly rate by the remaining contract period. Here's how you can calculate it:
Keep in mind, this projection covers just one standard deviation, implying that the price might move beyond this range.
Implied volatility (IV) isn't fixed; it fluctuates. This means the expected movement in option prices isn't steady—it can rise or fall due to various factors. Often, these changes happen gradually, but sometimes they occur suddenly, surprising new traders.
When the market sharply rises, especially after a period of decline, the fear of a bear market diminishes, causing a quick and substantial drop in an option's price.
Once news is disclosed, such as earnings announcements or reports from the FDA, implied volatility (IV) tends to drastically decrease.
When there's upcoming news related to a stock option, like an earnings announcement or FDA updates on a drug trial, buyers tend to be more eager than sellers. This increased buying interest leads to higher implied volatility, causing the option premium to rise.
Implied volatility and historical volatility are two different ways to measure a security's movement. Historical volatility tracks what actually happened with a stock by averaging its daily price changes over a year. It's useful for assessing risk and predicting implied volatility. However, it doesn't guarantee the future behavior of a stock or option.
Don't assume that the current price of an option or spread is the right value for your trading strategy.
This isn't something beginners should take lightly. Buying options when news is pending needs experience. You've got to be confident in gauging how option prices will respond to the news.
Simply guessing the stock's direction isn't sufficient when trading options. You need to grasp how much the option price might shift. That's when you can decide if it's a worthwhile move.
