Hello investors, in this post I would like to address a question I have been reading about lately. What influences implied volatility? Many people ask this question because they say that implied volatility is the only factor that determines the price of an option, and that is true, but it raises a good question: What determines implied volatility?
Table of Contents
- let’s start with implied volatility
- Implied volatility model
- What value of implied volatility does the market use?
- What affects implied volatility?
- Summary
let’s start with implied volatility
implied volatility is the volatility required to achieve the current option price.
In other words: What volatility do we need to input into a pricing model so that it produces an option value equal to the current market price?
let’s say that we have a stock trading
Stock = 100
Date to expiration = 30
Interest rates = 0
Volatility = 20
100 call = 2.28 cents
when I go to my broker’s platform and it is not trading for $2.28, it is trading for $4. How can we explain this discrepancy?
Let us go through them one by one to see what they could be. Could not it be another stock price? No, it’s the actual stock price in the market. Everybody sees the same price. That’s a fact, so we have to stay at 100.
this option has 30 days left until expiration, that’s a fact. what about Interest rates?
There is a little room for discrepancy here, some say it’s 0, others say it’s 2.5%,
but the point is that over a short period of time and with interest rates this low, it might make a penny on this option.
so that’s not going to make a significant change so what’s left is volatility.
you can see that the number we need here is not the number that occurred in the past, but the number that we expect to occur during the life of the option, or in this case, in the next 30 days.
Of course, that’s something that nobody knows, so the implied volatility just shows us the best estimate of the market, so when we see that $4 market price. what is the market predicting? What is the market’s estimate of this option when it values it at $4?
Implied volatility model
My broker’s platform shows you this in the implied volatility column, but where does this number come from? It comes from a pricing model. So let’s go to the OIC website and see how a pricing model can give us implied volatility.
that’s the options industry council, we have a $100 stock price.
$100 strike, 30 days to expiration, 20% percent volatility, and 0% percent interest rates.
by pressing calculate the pricing model says that the call should be trading for 2.28.
This is what we just saw earlier. but in my broker’s platform, this option is trading for $4.
how is that possible?
The only thing the market might disagree with us on is volatility, everything else is pretty much certain except for the interest rate.
but that’s not going to make a big difference it’s all about the volatility and what we need to know is the volatility over the next 30 days.
What value of implied volatility does the market use?
when we calculated that 20% volatility, we probably took it from historical volatility or our best estimate or something like that, but nobody is saying that the market has to use those values.
so it’s really hard to say whether an option is really fairly valued.
so what is the market using? if they are pricing this at $4,
by changing a couple of values, I could calculate and see what it does to the price until it becomes $4.
The calculator provides us with a nice little feature called implied volatility. The market price we assume is $4, and when we select “Calculate,” it says that the market must have a volatility of 34.99 – let’s just call it 35.
This means that if I change the volatility to 35 percent, I should get a call price of $4.
See what your broker’s platform does. It just works this pricing model backward and says, we know this is the current market price of the option, so this becomes a fact, and they say, well let’s work the problem backward and say what volatility is necessary to generate a $4 price.
we would call this figure implied volatility. It is implied or inferred because the options market is willing to trade at $4.
What affects implied volatility?
The question now is what influences implied volatility, and volatility factors.
There are a lot of potential factors that could be listed, but usually, they’re just broken down into finer details,
but they usually fall into three main categories
The first one is simply the current market volatility or what we might call historical volatility.
What has happened in the past, so we could say “in the last 30 days” or “in the last 60 days,” it was 20%.
That is probably a pretty good estimate for the next 30 days and statistically, that is true, which does not mean it will happen, but that might be a good starting point.
People’s expectations
The second factor is the expectation of a change in the current stock price, and this is where it gets really tricky.
We don’t know what news might come out that might cause big changes in people’s expectations,
or whether it’ll be bullish or bearish, but if people expect big changes in the stock price, even if they haven’t happened yet.
As a rule, volatility figures or implied volatilities increase. This is often the case,
When stock prices are stagnant or sideways before the earnings announcement.
While traders wait for the news to be announced, but the options market heats up and people offer calls or puts depending on whether they’re bullish or bearish.
By the put-call parity, they have to balance each other out, i.e., even if everyone flocks to the market to buy calls and drive up the implied volatility, the same volatility has to be more or less transferred to the puts, i.e., expectations play a significant role.
Supply and demand
If we have a big rush to buy calls, that will put buying pressure on calls, and call prices will go up, and therefore implied volatility must go up, or vice versa, if people sell.
Those three factors are highly interrelated, if expectations go up, then people will respond by either buying or selling, but all of your factors really fall into those three camps.
The hard one is to watch for unexpected events yes it’s true that implied volatility may be low now but a surge in demand can suddenly change that so the stock price doesn’t need to become more volatile we only need the market to expect it.
Summary
We can’t predict what news is going to come out that could cause those changes and in what direction those changes will be.
That is something you can’t predict and this is why it is so critical when you’re setting up your strategies.
Stress testing your positions is a must saying:
“Well, you know the past volatility it’s never gotten as high as 40%, so that’s not going to happen”.
That approach for unexpected events and changes in supply and demand can change that quickly.
Instead, always stress test your positions by asking what if? how it would behave and if you do that you’ll be on your way to making better decisions for your strategies.
If you like to learn more about options trading you can check some of my other posts:
What is the meaning of out of the money?
Is the covered call a good strategy?
Good luck.