Implied Volatility

 Think about two different companies that have the exact same stock price.

Now, let's consider the same option on those two stocks, an option with the same strike prices and same expiration date.

Now, why would the price of one option for a company be so different from the option on the other?

The answer: Implied volatility.

We will looking at how implied volatility affects options prices and how option prices can impact your choice of strategy.

Market volatility -> The VIX

What is implied volatility and how is it calculated and why is it important?

The relationship between stock prices and implied volatility.

When stock prices are expected to make a big move up or down, investors typically purchase more options. For example, suppose the market has been falling for a few days. This might cause investors to become more protective of their stock positions. As a result, these investors might buy more put options as a form of protection. This increase in demand suggests there's more uncertainty in the market. This leads to higher implied volatility levels, which helps market makers price in this high level of uncertainty.

One way to think of the effect of implied volatility on options prices is to consider a balloon,  where the balloon represents implied volatility. Now, when a balloon is inflated, it expands. Just as when implied volatility increases, the price of options increase along with it. Now similarly, when implied volatility decreases, options price decrease just like the balloon shrinking as air is released. 

Let's look at a measure of market volatility: the VIX. 

Investors look to the CBOE Market Volatility Index,to determine the implied volatility level for the overall market. This index tracks the implied volatility for the S&P 500 index options. If the VIX is rising, demand for options is increasing. and therefore becoming more expensive. If the VIX is falling, there's less demand and options prices tend to fall. To understand this relationship, put yourself in the shoes of a market maker. As a market maker, you sell a product, which like insurance grows in value if certain situations occur. So if you're sitting at your desk one day and you start seeing more and more orders coming in for an option, you might think these traders know something you don't and the markets will make a big move soon. So you'd likely raise prices to price in this uncertainty. These higher prices also have another effect. They attract option sellers. For example, suppose the level of uncertainty in the market increases and options premiums are now higher. Traders who felt the volatility was too high and would soon fall would begin selling options. and this is exactly what market makers want: more order flow. If more option sellers appear,  implied volatility levels will likely begin to fall.

Let's recap, the VIX tracks market-implied volatility, derived from the S&P 500 index options. Now options prices tend to move in the same direction as the VIX index, and when options prices are high, seller tend to enter the market.

Let's see how implied volatility factors into picking an option strategy. 

Consider the down-trending stock below picture:

 

An option trader wants to make a bearish trade. He might consider buying a put or selling a call. Both are traditionally bearish strategies that are designed to profit from a downward price move. For the purpose of this example, we'll hold off analyzing factors like cost and risk and use implied volatility to help assess which trade might be best. Generally speaking, short options strategies like selling a call can benefit from falling implied volatility. This makes sense, since these trades have negative vega, and the goal is usually for the price of the underlying to stay below the call strike in hopes that the option will expire worthless. On the other hand, long option strategies like buying a put can benefit from rising implied volatility. The goal is for the long option to gain value, and these trades are vega positive.

    As we wrap up, it's important to remember. Since implied volatility affects options prices, options traders may factor in implied volatility levels to their strategy selection decisions. When implied volatility levels are high, short option strategies can benefit from potential declines in volatility, and when volatility levels are low, long option strategies can benefit from potential increases in volatility.

Tools of the trade!

examining historical volatility, implied volatility, overall market volatility, which we'll see is in the index VIX, V-I-X.

Best way to start off, with just a quick definition of what we mean by implied volatility and historic volatility.

An easy way to remember that is implied volatility typically tells you what people think volatility is going to be. In other words, calls and puts, since their value is constantly changing in the marketplace, we can see from the price of calls and puts, how they're moving up and down, it gives us an idea of people's future expectations of where volatility will be between now and expiration of those options. On the other hand, historical volatility shows us what actually happened in the marketplace. So we can go back in time and actually chart what those levels of volatility actually were. Remember, implied volatility is telling us what future expectations are, or looking forward. And again, these are opinions that we're taking from current values of calls and puts, which are constantly changing. 

Let's take a look at S&P 500 index ($SPX) : timeframe 1 day 2 years

 

 

 We have a chart of how the market has behaved, the S&P 500 over the last two years. Let's take a quick look at thow implied volatility and historic volatility played out during that same time.

Click on the studies beaker -> Add study -> Volatility Studies -> ImpVolatility 

Click on the studies beaker -> Add study -> Volatility Studies -> HistoricalVolatility

Pic i&h

 As you can see(Pic i&h) feb 22, 2020 to april 17, 2020m, we can see the market started to move into a down move. We saw the market come down(candles measure how much the move is for that one particular day. Red/Orange candles giving us the idea or telling us that the market was down that day.) the implied volatility start to go up.( Implied volatility is telling us in the future what people think of volatility will be doing. (Volatility is measuring uncertainty in the marketplace.) The blue line is telling us over the last two years what the high and lows of implied volatility have been. 

When markets move down, we see pops in volatility. As the markets start to move up, implied volatility dropped down.

One important take away of implied volatility is it tends to move the opposite direction of the market itself. Volatility higher, markets moving lower.

When implied volatility move up, right after that historically volatility did go higher. Historical volatility is confirming what implied volatility was starting to bring to the forefront. When implied volatility started to drop, the historical volatility sorta held on for a while and then slowly drop down with the implied. 

VIX is the measurement of the overall market volatility. VIX is calculated by using the options on the S&P 500 index. So it takes the options the calls and puts on SPX, and from that derives the VIX or fear index. People will look at the VIX sometimes on a daily many people on a daily basis to get an idea of what is the relative expectation for implied volatility for the whole market? Many people make sure they keep VIX on their daily watch list so they can keep atop of where VIX is and where it's been historically sort of what its highs and lows are as well.

Earnings date -> implied volatility was moving higher going into those earnings releases. That is something that's fairly common. We'll see uncertainty starts to build, and that is reflected in the calls and puts, and they're telling us just before earnings are announced we tend to see a lot of uncertainty come into the market. When a company that's reporting those earnings, we typically will see a spike in the implied volatility. Because people are looking for a move in the stock up or down. They don't know which way, but it could be a rather significant move in that stock. 

Historical VS Implied Volatility

- Historical volatility is a statistical calculation

- Implied volatility is set by market makers' response to demand

- Volatility percentile = current volatility level in 1 year range

How volatility is calculated and why it's important?

What is implied volatility and what's volatility for the whole marketplace?

What kind of things really impact the VIX?

VIX is calculated by the price that people are willing to pay for calls and puts. That's constantly changing! We could take the options on the SPX(S&P 500), we could go back every month for a whole year, and pick the same options the at the money call and at the money put with exactly(20 days to go till expiration). You'd think that each month the same options with the same days till expiration would have the same price every month, but it doesn't. You'll find that option varies in 10, 15, 20, 30, 40, 50 cents from month to month, and the reason is each month people have a different expectation of what the market will be doing in the future. 

Earning calls or certain eco data can change the volatility of each stock.

Earnings are a great example of an individual stock, when people's expectations are that it's going to be a big move in the stock after earnings. We don't know if it's up or down, but we just know a big move is potentially coming. Options will reflect that. They'll pay more for the calls, they'll pay more for the puts for the people that think it's going up or down. We see the same thing in VIX. VIX are people who are buying and selling calls and puts on the S&P 500, and if they think that there's going to be a lot more volatility in the market in general. We'll see that reflected in the calls and puts of the S&P 500. 

VIX is important to check when you're going to be options trading. Two reasons:

1. When we see VIX start to pop up, that tells us that there's more uncertainty in the marketplace. As volatility goes higher, so do the price of calls and puts. We tend to see those two things go up in general. We can also price, how much the current levels of calls and puts are in price, compared to how they are historically. - The particular nature of VIX is very important. It's not like a tock. That can continue to go higher and higher over time. It tends to revert to the mean. It's called a mean-reverting product. When the market's moving along and the market sells off, we see a spike in VIX, but eventually markets stop and start to come back, then so does the VIX comes back down and reverts to its mean price. VIX is not going to rise or decline gradually over time like some of the others. 
2. We tend to see an inverse relationship between the market overall and the movement of VIX. Here's one thing that many traders do. They will use the VIX as a tool or a gauge to sort of to generate/compare what sort of certainty they have in the market movements they are seeing. If the market really went down and the market started to crash, they would expect to see Fear and uncertainty spike up. When VIX popped up and the market sold off. If we see the market start to go down, traders don't see VIX go up(VIX just stays where it is/maybe goes up just a little bit) that's a bit of a warning sign. That alerts traders to say, "Wait a minute, the market's selling off, but there's no fear or uncertainty coming in as reflected by the VIX." Why does that happen? => Because people are thinking this move that we're seeing in the market this particular day might not be long-lived. It might be a very short a one-time, nonrecurring event. So they're just thinking,"hey, maybe one bad news for today, but we don't expect to see that affect the market over the long term." When the market to sell off for most substantial reasons, then VIX might go up and stay up for a while before it reverts to the mean because we're not sure how long this downward move might last. If you do see a market come down for a day and there's no spike in VIX, that's a little of a warning sign to people to say, "hey, wait a minute, the market's really not showing any fear for this down move." Maybe they're not thinking this is going to be a lasting down move. Maybe the market will reflect the next day or the following day. These can be one time daily events or one time nonrecurring events. Sometimes you'll see at the end of a quarter, they'll re-balance and there'll be a lot of stock sales on the close of that particular Friday. That doesn't have anything to do with Monday. Once that rebalancing is done, we're back to Monday, and now the market is trading on new information, and maybe the market goes right back up. That's why you might not see VIX pop on. The VIX is something that's changing week to week. 

What is implied volatility?

Implied volatility is kind of like the VIX. VIX is implying what the market volatility is going to do. 

Let's do example with FB(facebook)

So options on one stock like FB, they are giving us an implied volatility for FB itself. So we can see what the expectations are for FB by looking at its options. 

Let's go to the trade page, you can see by looking at the calls and puts in FB, just like VIX does for the SPX, they are giving us an implied volatility, what they think the stock is going to be doing in the future based on upcoming events and things like that. It's all reflected in the price of the calls and puts. 

Example:

You can see that we're moving up to this particular date(earnings date). Add -> implied study...  

Look, as the candles moving up, volatility was kind of moving sideways, but we knew we were moving towards an earnings announcement, so volatility actually rose up into that earnings. That's interesting. Because typically as a stock or the market's going up, we tend to see implied volatility go down, but not when we're moving into an earnings play. Volatility kind of held sideways, and implied volatility actually went up slightly. Once earnings were released, the stock had a pretty big selloff, but guess what, implied volatility still came back down. we oftentimes see this spike in implied volatility going into an earnings announcement. So not unusual. Trade page => we can see implied volatility for all the different expiration dates by going straight across and holding your mouse over the number and it will says implied volatility. This is important because implied volatility is assigned to each expiration date, and you can see how these implied volatility numbers change quite a bit over time. They seem to increase overtime. That's typical. If you see sometimes implied volatility jump up in a month earlier than the other ones, you'll see something up there in the tab (straight from ticker place holder) called the Market Marker Move, and that's giving you Market Maker Move tells you how much they expect the stock to move based on this sort of inversion, as we see of implied volatility level. Typically implied volatility moves higher slowly but surely higher as time goes on, and sometimes we might see it really jump up if that is a week when earnings will be announced. The Market Maker move show the stock might do the next day.