Finally giving you guys a break from the Greek terms! In yesterday’s article we discussed Theta, a crucial concept to understanding how to trade profitably. Today we will discuss another critical concept in option contract pricing: Implied Volatility (IV).
What is Implied Volatility?
Implied volatility is the estimated volatility of a stock’s options contracts in the future. It is sometimes denoted by the Greek letter Sigma, but it usually referred to as IV. Like with historical volatility, this is expressed on an annualized basis. It is typically more of interest to retail options trader than historical volatility because it is more forward-looking.
In general, implied volatility will increase when the market is in a bearish trend, and decrease when the market is in a bullish trend. Implied volatility is a method of estimating future fluctuations in a stock’s value based on specific factors. It is a crucial factor in the pricing of options contracts. You want to use options that are at the money to determine what IV is for an option.
Factors That Affect IV
There are a variety of factors that affect a contract’s implied volatility. Many of them are based on events affecting the price projections of the underlying stock. It could be an earnings announcement, statements from an FOMC meeting, drug trial results, and other events that will likely affect the price projection. The higher the value, the more expensive the contracts are since there is more premium due to the higher risk investment.
IV is expressed as a percentage of the underlying stock price. You just need to understand a very basic statistical concept to understand implied volatility: A stock should end up within one standard deviation of its original price 68% of the time during the upcoming a year, a 95% chance it will end up within two standard deviations, and 99% of the time.
Don’t be intimidated by the math. I am just explaining that so you know how it is calculated. You do not have to worry about that for buying and selling contracts.
Let’s say that imagine that the stock is trading at $50, and the implied volatility of a call option contract is 20%. This implies there’s a consensus in the marketplace that a one standard deviation move over the next 12 months will be plus or minus $10 (since 20% of the $50 stock price equals $10).
Here’s what that means in plain English: the marketplace thinks there’s a 68% chance at the end of one year that SQ will wind up somewhere between $40 and $60. It also means there is about a 32% chance the stock will be trading above $60 or below $40.
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