Right Direction, Wrong Options? Your Problem Might Be Implied Volatility

In our last post, we were discussing end-of-day pricing vs. real-time data. In options, a lot of different variables go into pricing these contracts. One of those inputs is referred to as implied volatility.

Implied volatility, or IV, is an input that many traders have likely heard of, but may not fully understand. However, understanding IV on a higher level will help sharpen the edge for traders in the options world.

What is Implied Volatility?

So what exactly is implied volatility and how does it impact options pricing? Put simply, when volatility is high, it increases the prices of options. Conversely, when volatility is low or falling, it decreases options pricing.

Examples of IV are easy to spot. Notice options premium for a low-volatility stock like General Electric (GE) generally costs much less than a more volatile stock like Twitter (TWTR). You may also notice an instance where one stock — say, Twitter — has an IV reading of 40 for a few months, but that it spikes to 50 in a certain month down the road.

That can be a sign of investors pricing in an extra volatile event such as earnings. Because stocks tend to post big moves after releasing their quarterly earnings results, this “extra volatility” is priced into options. It’s not just earnings either. It can be related to an FDA announcement, annual shareholder meetings or product conferences.

That’s the simple answer. But implied volatility is a much more complex formula — and it isn’t an exact formula either. For instance, investors might price in an 8% move for a stock on earnings. Say the reaction is very muted — just a 2% move in the stock price, for instance — then the option suffers what the Street refers to as “vol crush.”

The term, short for volatility crush, essentially means that because the underlying stock didn’t move as much as anticipated, the option still suffers heavy damage because the implied volatility was priced too high. That “extra volatility” we mentioned earlier gets sucked out of the option’s pricing and it “crushes” the premium lower.

A Vol Crush Example

An at-the-money Twitter call option expiring in June trades with an IV of 35. The next month, July, trades with an IV of 45 because it captures the company’s earnings results. However, as the earnings date approaches, that IV number generally gravitates higher, causing the premium to increase as well. Let’s say the $18 at-the-money call costs $1.00. Investors are expecting volatility, pricing in an 11% move.

Once the company reports earnings though, the event is over and the results are known. Thus, even on a move higher — say, a 4% rally — the call option actually loses value because so much more volatility was priced into the contract. That’s how traders be right on the direction and still lose money in the options market.

Two Sides to Every (Volatile) Coin

Vol crush is just one way we experience volatility changes in options. But there are more. If a stock has seen a sudden decrease in its price, or in the event of a market-wide pullback, we tend to see IV move higher. As we mentioned before, an increase in IV makes an option more expensive to buy. For sellers though, it can be more lucrative. The pro to selling options in a rising IV environment is be seen in the form of collecting a larger credit. The con however is that the stock is more volatile and the position could move against the trader more than expected.

Some premium sellers will attempt to capture these events in one of two ways. The first, they may believe a particular event is pricing in too much volatility. Let’s say the average move for Twitter following earnings is 8%. If traders are pricing in 15%, an option-selling trader may take advantage of that, selling options and hoping for a more muted reaction of the stock.

The other type of premium seller will wait for the move to happen. Let’s say Twitter were to announce out of the blue that user growth is stalling this quarter. This would catch investors off-guard and send the stock lower. When stocks are in decline, volatility is generally on the rise. But when that decline is swift, deep and especially unexpected, volatility tends to rocket higher. That’s why option sellers may use that situation to their advantage, perhaps by selling put options when volatility is rising and the stock is falling, looking for that IV to dissipate over the next few trading sessions.

Volatility is an important factor for premium sellers to consider. While a high volatility environment can be both lucrative and dangerous, so too can a low vol environment. A low vol environment not only makes for smaller credits to collect, but can be risky should a sleepy market start to experience a nightmare. Not only can the position move against an option-seller — for example, the price of the stock goes down, hurting those who are short puts — but an increase in implied volatility boosts the option’s price even more.

How Do We Calculate Implied Volatility?

IV is just one factor in the Black-Scholes Model, the go-to when it comes to option pricing. To refresh your memory of how this pricing model works, refer to our piece, Black Scholes Formula Explained.

“The volatility of the stock price is one of the most important factors for option pricing,” it says. Because we can go online or to our broker and pull up a particular option’s pricing, we don’t need to manually calculate all of the figures in the Black-Scholes Model. This makes our life much easier, especially because the volatility figure is constantly changing.

For the old-schoolers, calculating the amount wasn’t too bad. But it was a constant change that made them estimate often. But really, their goal comes down to the same as today’s traders: Figure out if the option is pricing in too much volatility or too little.

Understanding how volatility impacts option pricing is one of the most important things for a trader to grasp, as it not only can help them profit in certain scenarios, but also avoid major risks.

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