Investing > Complete Guide to Implied Volatility

Complete Guide to Implied Volatility

The stock market can be a scary place to navigate without a map—but thanks to implied volatility, making an informed prediction is possible.

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Updated February 10, 2022

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Do you wish you had a crystal ball that would let you see the future? 🔮

Unfortunately for you, those definitely don’t exist.

What does exist in the stock market, however, is something known as implied volatility. This is a calculation based on market variables that can give you an idea of what the future price of a certain stock might look like.

But before you get too excited and start texting all your friends saying you know which direction a stock is going to go, it’s important to know that implied volatility numbers are just predictions. And although they are calculated using specific mathematical functions, they aren’t always correct and are subject to being affected by current events.

This can be seen in the post-COVID stock market of 2020 where multiple stocks reported low implied volatility—only to get crushed in the summer of 2021 as the delta variant began to sweep the nation. This is why it is so important to understand what implied volatility does and doesn’t mean when it comes to stock prices.

The point is, investing in stocks is risky, but with numbers like implied volatility, you can head into your trading session with a better idea of how a stock will change in price over time. But first, keep reading to be sure you educate yourself about what implied volatility is, and how you should properly use it when making stock decisions.

What you’ll learn
  • Implied Volatility Definition
  • Understanding Implied Volatility
  • How to Find Implied Volatility
  • How to Calculate Implied Volatility
  • How Implied Volatility Affects Options
  • How Implied Volatility Affects Pricing Options
  • How To Use Implied Volatility for Trading
  • Pros and Cons of Implied Volatility in Trading
  • Implied Volatility Trading Tips
  • Get Started with a Broker

What is Implied Volatility? 📖

Implied volatility is a term that refers to a certain measurement that establishes the likelihood a particular market is to change over time. So a security with a high volatility will be one that has a price that is going up and down quite frequently, while a stock with low volatility will have a price that is fluctuating much more slowly. 

Thus you can think of implied volatility as the probability that the price of a certain security is going to change over time. Whenever you see an implied volatility number, it will be a percentage and denoted by the Greek letter sigma (Σ).

This number is also used by investors to predict how the supply and demand of a certain security will affect its price. For example, toilet paper was all the rage at the beginning of the coronavirus pandemic, but if you had looked at the implied volatility of the toilet paper stocks, you would see that it was quite high—because the demand for toilet paper increased very suddenly in response to an event rather than increasing naturally. 

Then, as the rush began to slow, the volatility returned to normal, only to surge again in 2021 as the delta variant began to arrive on US soil. Why toilet paper has anything to do with COVID-19, investors have no idea, but the brand behind many toilet papers, P&G reported increased volatility in their stock due to ramped-up toilet paper production. 

CBOE Volatility index
The CBOE Volatility index (VIX) is an indicator of overall market volatility (S&P 500). Image by TradingView.

Besides just using implied volatility when it comes to picking stocks, the number is also used to calculate the value of an options contract—something which will be explained in more depth later.

Understanding Implied Volatility 📚

Implied volatility isn’t just a random guess of what is going to happen in the marketplace, rather it is a number that is calculated using many known variables. Therefore it is the forecast of a specific security based on the conditions of the market itself.

The problem with implied volatility, is it does not tell you whether the price will go up or down, rather it just tells you by how much you could expect the price of a security to go one way or another. Therefore, a high-volatility security is just a security of which the price is expected to change drastically or frequently, and a low-volatility security is unlikely to see any price changes at all. 

How Can You Find Implied Volatility? 🔍

Implied volatility can be found using a couple of different formulas. The most commonly used one is called the Black-Scholes method, but Newton also has an equation that can be used. These equations are quite complicated, and it is often better to leave the calculation to professionals and get your implied volatility data from a trading app or website.

Many of the top brokers for options trading offer free implied volatility data. However, these services also have limitations for their ‘free’ usage. 

Therefore, most serious stock traders use a leading options alert service to deliver them implied volatility data or they use a charting tool to get their information. While these tools help professional brokers gain insight into the market, anyone who pays for the services can get information just as quickly as a professional day trader.

While implied volatility can be a good gauge of how a stock will perform, it can change at a moment’s notice as the market changes. It can also change directly after a trade is executed. This is why options stocks with a longer period until expiration are more volatile—because there is more time left for them to change. 

What Factors Are Used to Calculate Implied Volatility? 🧮

Now you are probably wondering what factors are used to get this magical implied volatility number. And the truth is, there are a couple of different ways you can calculate implied volatility, but both equations generally require the input of the same factors.

But the major determining factor when it comes to calculating implied volatility is the law of supply and demand. This is because supply and demand have a huge effect on the prices of securities. When there is a higher demand the price will rise, and when the supply rises, the price will drop.

Besides just supply and demand, another factor that affects implied volatility is the amount of time an option has remaining before it expires. Options that have only a few days left, or are only given a few days to begin with, tend to have a lower volatility, while options with more days left have a higher volatility. This is because the more days left on the option, the more chances a security has to drastically change in price.

This image illustrates the factors that determine implied volatility
Some factors that determine volatility depend on the conditions of the options contract, whereas others are determined by the markets.

A recent example of where this occurred was in the trading of cryptocurrency options, more specifically Ethereum. As options contracts began to approach expiration because of the blockchain upgrade, the stock itself experienced higher volatility. 

You can think of this a bit like looking at the weather forecast. When you look at the forecast for the afternoon or the next day, there is a higher probability that it is correct (i.e. less likely to change or less volatile) than when you are looking at the weather a week in advance. This is because meteorologists are usually more able to accurately predict what is just over the horizon than weather that is still forming.

How Does Implied Volatility Affect Options?

First of all, it’s important to know that options are a specific type of stock contract that gives the buyer the choice and ability to buy or sell a specific stock before a date as outlined in the contract by paying a premium price. Options contracts are generally favored by day traders because they help to limit risk and damage to a stock-based portfolio. 

Why is risk limited? Well, this is where implied volatility comes into play. As mentioned above, implied volatility is a number that is calculated based on certain market conditions. Then this number is used to derive the price of the options contract. 

Therefore an options contract with low volatility will likely be cheaper—because it is less risky—while an option for a stock with higher volatility will be more expensive. This enables a trader to evaluate risk before they buy, and if they do purchase the option, and the stock goes south, they can choose not to execute the contract, therefore having explored the market without damaging their portfolio. 

How Implied Volatility Affects Pricing Options

Now that you are aware that implied volatility plays a major role in options pricing, it’s important to explore just how it affects pricing options. There are currently three different pricing models used when calculation options pricing. 

The first model is the most commonly used one known as the Black-Scholes model. This model uses several factors such as current stock price, time till expiration, and risk-free interest rates when calculating prices. 

The only problem is, while this method works for international options that can only be executed at a specific time, it doesn’t work well for American options, as these contracts are allowed to be executed any time up until the execution date so using the time until expiration isn’t a very accurate calculation for these options.

Thus, many American companies use a different method, known as the binomial model. This model is performed using a tree diagram with several different levels. 

Each level features a different execution time and has volatility factored into it—to show the numerous possible outcomes available with that stock option. Thus, the binomial model works best with the American system where options can be executed at any time because you can see the outcome if you were to sell the selected option at any given time before it’s expiration.

The third pricing model is called Newton’s Model or the Bisection method and it combines the Black-Scholes method with a more precise equation designed by Isaac Newton. This equation requires variables that are discovered in the Black-Scholes method, but then uses additional variables such as looking at the implied volatility of the stock during other points in time on the market. 

This is a very difficult calculation to perform by hand, and it is typically only performed by computers. Generally, you will find this method in use by traders who also know how to code, as this is the easiest of the three methods to code on a personal level. 

How To Use Implied Volatility for Trading 📈

Implied volatility is a great way to pick out a strategy for your options trading. It’s important, however, that you understand how implied volatility works before you start throwing all your money into options contracts. 

The best way to use implied volatility is by looking at a chart of historical rates of volatility. This can give you an idea of the implied volatility you can expect in the future for a particular stock. Using these charts, most traders employ them to try and find undervalued options to buy, while selling overvalued options that they believe will go down in the future.

Looking at a chart of historical rates of volatility can give you an idea of the implied volatility you can expect in the future for a particular stock.

This is a forecasting technique, and being aware that high and low volatility times come in waves, can help a trader to fine-tune their technique for trading options. Of course, this isn’t a sure thing, and your predictions won’t always be right, but this is a decent strategy to follow and it can help you to develop other strategies to use when trading in your portfolio. 

A real-world example of a highly volatile stock is Tesla, which experiences high volatility due to the fact that it is new technology that frequently experiences supply and demand issues. Therefore looking at the history of the implied volatility of Tesla can help you decide on when you should buy and or sell your Tesla options. 

Pros and Cons of Using Implied Volatility in Trading ↕️

Like any type of stock market trading in the world, there are many pros and cons to using implied volatility in trading. And you should definitely take a look at the pros and cons before you devote yourself to using implied volatility to trade options. 

Pros 👍

The major pro to using implied volatility in trading is that it can help you gauge the uncertainty of the market. Therefore you will be able to recognize if it is simply you gauging a stock as volatile, or if the market agrees with you. Additionally, stock volatility can help you decide how much money you will put into one as opposed to another, while also helping you decide when a specific stock should be sold.

In the present market, implied volatility can be helpful when it comes to deciding on riskier investments to put your money into—like cryptocurrency. This doesn’t mean it will lower your risk, but it can help you to decide the probability that a certain asset will change. One successful cryptocurrency trader, Glauber Contessoto, used implied volatility to decide to go all-in on Cardano

Cons 👎

Meanwhile, the cons for using implied volatility can be quite vast. This is because implied volatility itself is volatile. 

Implied volatility numbers are subject to change with news reports, current events, or even large trades. This happens because they are almost solely based on prices and don’t always factor in the rules of supply and demand into the equation. 

And remember, volatility doesn’t say whether the price will go up or down, just that it is expected to move. This means using implied volatility in trading is a risky tactic in and of itself, although, if there are no news releases affecting your particular stock, it can be a great way to gauge how a particular stock may perform.

If you want an idea of just how quickly implied volatility can change, it’s a good idea to take a look at charts surrounding the announcement that the government was looking to increase interest rates. Although the rates have yet to increase, the implied volatility of the market has already reacted to the news, increasing as a response to the announcement.

Pros

  • Can gauge market uncertainty
  • Can help you calculate the risk involved in a trade
  • Can help you develop a trading strategy

Cons

  • Prone to be affected by news/current events
  • Mostly based on price, other factors are excluded in the calculation
  • Only shows how much the price will change, not the direction.

Implied Volatility Trading Tips ⭐

Have you decided that you would like to use implied volatility as you trade stocks? Then it’s important to keep in mind the following tips as you use implied volatility to trade options

Investigate the Volatility Thoroughly 🔬

Be sure to determine whether the volatility is rising or falling on a particular stock before you buy. Remember that volatility is just how much you can expect a stock price to move, it doesn’t tell you which direction.

Know Your Strategy Before You Begin 📅

Before you start to put your money on the line, create an options trading investment strategy for yourself. Are you looking for stock options with low or high volatility? What do you plan to do with them? Being certain you can answer these questions before you begin trading can help you to avoid unnecessary risks. 

Know There is a Reason for Everything 🤔

If you find a stock option that seems to be out of the normal, i.e. an option that seems too good to be true, or very expensive, know that there is a reason for this. Check the news. Likely something has happened to affect that option. Never buy what you think is a good deal before investigating why it is a good deal first. 

Remember Buy Low Sell High 💱

Trading options while using implied volatility generally works the same way as the regular market. So when you see stock options with high volatility, this should be a trigger that you should try a selling strategy. And when you see a stock with a low implied volatility, then it may be time to try a buying strategy. 

Conclusion ✒️

Overall, learning about implied volatility really can help you to develop a map for navigating the stock trading world. But like anything else in the stock market, implied volatility itself is volatile and you should always be sure to investigate all of the reported numbers you see—especially because implied volatility doesn’t tell you in which direction a stock is expected to be negative.

However, if you spend some time learning about and analyzing implied volatility, you will likely develop some pretty neat strategies for options trading that can make you a successful trader. Just keep in mind the general rules of the market, such as buying low and selling high, and soon you will be trading stocks based on implied volatility with confidence. 

Implied Volatility: FAQs

  • Is High Implied Volatility Good?

    High implied volatility can be both good and bad. High implied volatility just means that the price is expected to move either up or down by that amount. This means you could make a lot of money, but you could also lose a lot of money with that stock.

  • Is 100 Implied Volatility Considered Good?

    100 implied volatility means the stock can increase in price by 100% or decrease in price by 100%. This means that it is very risky to invest in this stock, but the final outcome could be doubling your money, or losing it all. 

  • What is a Good Volatility Percentage to Look for?

    The best implied volatility percentage to look for will depend on the type of investing you are trying to engage in. If you want less risky investing, then go for low volatility stocks. If you want more risky investing, then go for high volatility stocks. 

  • How is Implied Volatility Calculated?

    Implied volatility is calculated by taking the price of a stock on the market, and putting it in an equation that takes into account the time till the option expires, as well as other conditions of the marketplace. 

  • What Does Implied Volatility Measure?

    Implied volatility measures the probability that a certain stock will change in price. This measurement does not tell you whether the stock will change up or down. 

  • How Do You Know if a Stock Has High Volatility?

    A stock that experiences many price fluctuations is a stock that is considered highly volatile. You can see this by looking at the price history of a stock, although many online trading platforms and applications will calculate this number for you. 

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