Demystifying implied volatility

Options have an advantage over other financial instruments. We have seen that several factors influence option price or premium. Success rate of an option trade can be enhanced if we understand implied volatility.

In financial literature the implied volatility of an option contract refers to the volatility of the underlying instrument and when this is used as input in an option pricing model such as Black Scholes it will give a theoretical value equal to the current market price of an option.

To better understand implied volatility and how it drives price of options, let's first dive into the basics of options pricing. Option premiums are derived from intrinsic value and time value.

Time value is the additional premium that is priced into an option, which represents the amount of time left until expiration. The price of time is influenced by various factors, such as the time until expiration, stock price, strike price, and interest rates.

How implied volatility affects options

Implied volatility represents the expected volatility of a stock over the life of the option. As expectations change, option premiums react accordingly. Implied volatility is directly influenced by the supply and demand of the underlying options and by the market's expectation of the share price's direction. As expectations rise, or as the demand for an option increase, implied volatility will rise. Options that have high levels of implied volatility will result in high-priced option premiums.

Likewise, if the market's expectations decrease, or demand for an option diminishes, implied volatility will decrease. Options containing lower levels of implied volatility will result in low option prices. This is important because the rise and fall of implied volatility will determine how expensive or cheap time value is to the option, which in turn can affect the success of an options trade. For example, if you buy options when implied volatility increases, the price of these options climbs higher. A change in implied volatility can create losses even if your view is right about stock direction.

Each option has a unique sensitivity to implied volatility changes. For example, short-dated options will be less sensitive to implied volatility, while long-dated options will be more sensitive. This is because long-dated options have more time value priced into them, while short-dated options have less.

Each strike price will also respond differently to implied volatility changes. Options with strike prices that are ATM are most sensitive to implied volatility changes, while options that are further ITM or OTM will be less sensitive to implied volatility changes. Vega determines an option's sensitivity to implied volatility changes.

Remember that as the stock's price fluctuates and as the time until expiration passes, Vega values increase or decrease, depending on these changes. This means an option can become sensitive to implied volatility changes.

(The author is a homemaker, who dabbles in stock market investments in free time)