Implied volatility is not Historical volatility

Being an options trader, you need to understand both concepts regarding volatility: historical volatility and implied volatility.

Historical volatility is defined as “the annualized standard deviation of past stock price movements.”. In essence, this shows how much the stock price fluctuated on a day-to-day basis over a one-year period. So, the thing to remember is that historical volatility reflects the price movements of a particular stock.

On the contrary, Implied volatility isn’t based on stock price movement. Instead, it’s what the market participants are “implying” about the stock volatility will be in the future. This is based on the premium (or price of an option) of its options. Based on the news in the market, option prices will begin to change like stock also moves. For example, one event that drives up the implied volatility and consequently options premium (or prices) is an earnings announcement. This is independent of stock price movement.

Both historical and implied volatility is expressed on an annualized basis. But implied volatility is the value to focus on to any option trader because this is the basis of the premium (or price) to pay for a particular option (Call or Put).


Compare both charts for SPY and TSLA is a given period. In the below chart of each (light blue line), you can see the implied volatility chart. 

Implied Volatility trading implications

Before entering into details about Implied Volatility (or IV) and its huge relevance on options trading, I would like to point out that, I base all my strategies (entry and exit points) dependent on Delta values than on stock or ETFs price movements (or price points). This is because Delta also varies with IV (and time, quote position, etc). My strategies are based on probabilities and when applied will adapt to each moment's market conditions! So, when I open a trade with at a 30 Delta Call in a low IV environment, probably this means a 3% move from the actual price. But, maintaining the same strategy in a high volatility environment, could mean an 8% move or more! As you can conclude, when dealing with options it is better to think about probabilities than of percentage price move! What I mean is, if you sell a Put 10% OTM (Out-the-money) because you expect to collect a premium due to the stock move higher or staying at the current level it does not mean anything to me if I cannot understand if that stock is low or high volatile. If you tell me that you are selling Put at -10 Delta, this has a different meaning to me! It does not matter, in this case, if a stock is high or low IV… you sell a Put to collect premium with an average chance of 90% of the options expiring worthless at expiration.


What is Implied Volatility?

When you trade stocks, only price variation enters into the equation because if you are expecting it to move up, you simply buy the stock (or short the stock if you expect it to move down). When dealing with options, many factors will impact its price. The Implied Volatility (or “IV”) is the main driver that impacts the value of the option. When you take a long position in a stock you expect it will increase in price. When you have a net long position in options you expect its Implied Volatility is low and expect its IV will increase in the future (well, there are other factors involved, but in a simple way, this is what to expect). So, like in stocks, “Sell High and Buy Low” also applies but for IV in Options! We need to select the options strategies to apply and we should take the IV level into account! In fact, I check more often the IV level of a Stock than its price chart (I am an options trader; not a stock trader!).

Implied volatility (IV) is determined by the current price of options contracts on a particular stock, ETF, or future. Its value is a percentage that indicates, at the moment, the annualized expected range of 1 SD (Standard Deviation) for the asset-based on option prices. You can see in Picture 1 that, statistically, one standard deviation will encompass approximately 68.2% of outcomes in a sample. When it comes to Implied Volatility, one standard deviation means that there is approximately a 68% probability of an asset settling within the expected range as determined by options prices.

In picture 2 there are two curves that illustrate two assets under different levels of IV. By means of comparison, if both assets have a similar price, the options prices will be more expensive on the blue one than the black one.

Implied volatility is a projection by market participants of how much market movement is anticipated for a specific underlying – regardless of the direction. In other words, implied volatility reflects the expected range of potential outcomes and uncertainty around how high or low an underlying asset might rise or fall. High implied volatility indicates there is a greater chance of large price swings expected by traders whereas low implied volatility signals that the market expects price movements to be relatively tame. Implied volatility measurements can also help traders gauge market sentiment considering IV broadly depicts the level of perceived uncertainty – or risk.

Illustration

Below you can check the options price of two assets, QQQ and FB, currently at similar stock price (circa 370). You can now see that for an ATM Put at the same expiration where the IV of FB (30,43%) is higher than QQQ (18,30%) and consequently, options prices are much different (9.12 for QQQ and 14.90 for FB).

Example: Impact of IV in a FB Iron Condor

In the following 3 figures taken from thinkorswim platform, you can see an Iron Condor profile on FB (Facebook). The stock at the time of the simulation was at 359.90. For the sake of comparison, the short strikes on the Put and Call sides were entered around 20 Delta and maintained at those strikes.

Figure 1 - Base Case where the Implied Volatility is on average for all strikes around 37%.

Above you can see that the maximum profit of the Iron Condor is circa $350 for a max loss of roughly $650. This delivers a Risk / reward of 1.85.

Figure 2 - Simulation the options Implied Volatility decrease 5% on average, maintaining all variables constant. And now sits roughly at 32%.

Even though the price of FB did not change, the effect of the reduction of the average implied volatility delivered a profit of $60.80 because the Iron condor is a negative Vega options strategy. So, when you open positions with this strategy the trader expect the IV in the future to drop because it helps. This strategy is best used when IV is high. Remember "Sell High, Buy low". In options are the same but it applies not to the price but the options premium.
In the TSLA chart above, if the trader had entered an Iron Condor at the IV peak (8 Jul), it would be benefiting  a lot from the trade because TSLA did not move too much, implied volatility crashed and some time has passed... all good signs of a very nice and profitable Iron Condor trade


Figure 3 - Simulation of the same Iron Condor but in a low implied volatility situation.

Now, it is easy to understand the impact of IV in the Iron Condor options strategy, a Vega negative strategy. In the above structure, under a low IV environment, the maximum profit of the Iron Condor is now circa $225 for a max loss of roughly $775. This delivers a Risk / reward of 3.44! Much riskier than under a high IV environment.


How to calculate Implied Volatility?

Given the IV of each option, we can compute the 1 standard deviation expected range (this will have a 68% chance to happen) for a stock's price after one year:

Expected 1-year range = Stock price * (1+ IV) for the top of the range and Stock price * (1-IV) for range minimum.

For one year's expected moves, simply multiplying the stock price by implied volatility will do. However, for shorter time frames, the expected range calculation must be adjusted with the expiration date. Here is the formula for calculating a stock's one standard deviation move for any time period:

Stock Price * Implied Volatility * SQRT (Calendar Days to Expiration / 365).

In the given example, for QQQ:

368.20 * 18,32% * SQRT (55/365) = 26.15

It means that QQQ can vary +-26.15 in the next 55 days (or 342 to 394)


How to Use Implied Volatility to support your options trading? 

As the community members at myoptionsedge know, my most important chart is the implied volatility one. Secondly, I am looking at the "normal" price chart of a particular stock or index.  On the charts above of QQQ and TSLA, taken from thinkorswim platform, you can easily see that implied volatility (the blue line below) is moving in cycles, with peaks and lows, but usually around its average.

This is important to take into consideration your options trading decisions because a trader will get an idea of how to determine a relative implied volatility range (or IV Rank). This will help the trader to determine when implied volatility is high or low, relative to its mean in a recent timeframe. If an options trader concludes the IV is relatively high, he might forecast a future drop in implied volatility or a reversion to the mean (or determine if implied volatility is relatively low, he might forecast a possible rise in implied volatility or a reversion to the mean).  Implied volatility, like everything else, moves in cycles. High-volatility periods are followed by low-volatility periods and vice versa.

This will impact the strategy to choose. When Implied Volatility is high the trader should choose Vega negative strategies like Iron Condors or Butterflies. This will give an extra edge to the trade because not only Theta (or time decay will be in his favour) but also when IV drops, the trader we gain from the negative Vega position. On the contrary, Strangles or Straddles perform better when opened in a low IV environment. The Calendar spreads work also well under a low IV environment but due to their different expirations, there are other factors to consider. Nevertheless, time decay (positive Theta) is on the trader's side.


Key Takeaways

1. Historical volatility is not correlated with Implied Volatility;
2. Implied volatility is the key measure for options traders;
3. Implied Volatility measures how much an underlying price is likely to move up or down in a specific period of time (from the perspective of the options market)
4. When earnings announcement approaches, it is likely that implied volatility increases despite price movement
5. The implied volatility level impact the options strategies to choose when opening a trade