When returns become too volatile they become unpredictable. That is the time when the asset becomes less valuable. Normally stocks that are too volatile are not preferred by investors and they command a lower valuation. But did you know that the reverse applies in case of options. In fact, volatility positively impacts the values of call options and put options. Normally, volatility and asset prices are inversely related.
Higher the volatility, higher is the risk and when the perceived risk is high lower are the returns compared to expectations. Investors are always more willing to pay for safety rather than for volatility. But when it comes to call and put options, the scenario is entirely different.
Calls and put options actually gain in value when the volatility in the market increases. So, let us understand why option prices increase with volatility. Let us also understand the relationship between option volatility and pricing.
How does that impact the implied volatility call vs put? Let us look at the impact on call options first.. Volatility and their impact on call and put options What do we understand by volatility? It means that the returns on the stock are likely to be volatile around the mean.
It also means that the level of uncertainty is too high in this case. Option premiums are manufactured from two main ingredients: intrinsic value and time value. Intrinsic value is an option's inherent value or an option's equity. The only factor that influences an option's intrinsic value is the underlying stock's price versus the option's strike price.
No other factor can influence an option's intrinsic value. This is where time value comes into play. 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. Still, none of these is as significant as implied volatility. Implied volatility represents the expected volatility of a stock over the life of the option. As expectations change, option premiums react appropriately.
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 increases, implied volatility will rise. Options that have high levels of implied volatility will result in high-priced option premiums.
Conversely, as 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 cheaper 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 can, in turn, affect the success of an options trade. For example, if you own options when implied volatility increases, the price of these options climbs higher.
A change in implied volatility for the worse can create losses, however — even when you are right about the stock's direction. Each listed 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 based on the fact that 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 near the money are most sensitive to implied volatility changes, while options that are further in the money or out of the money will be less sensitive to implied volatility changes. Vega —an option Greek can determine an option's sensitivity to implied volatility changes.
Keep in mind 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 more or less sensitive to implied volatility changes.
One effective way to analyze implied volatility is to examine a chart. Many charting platforms provide ways to chart an underlying option's average implied volatility, in which multiple implied volatility values are tallied up and averaged together. The same can be accomplished on any stock that offers options. The figure above is an example of how to determine a relative implied volatility range. Look at the peaks to determine when implied volatility is relatively high, and examine the troughs to conclude when implied volatility is relatively low.
By doing this, you determine when the underlying options are relatively cheap or expensive. If you can see where the relative highs are, you might forecast a future drop in implied volatility or at least a reversion to the mean.
Conversely, if you determine where implied volatility is relatively low, you might forecast a possible rise in implied volatility or a reversion to its mean. It is simply the demand over supply for that particular option, and nothing more. Generally, in a rising market, calls will generally have a higher implied volatility while puts will have a lower implied volatility; in a declining market, puts will have a higher implied volatility over calls.
This reflects the increased demand for calls in a rising market and a rising demand for puts in a declining market. A rise in the implied volatility of a call will decrease the delta for an in-the-money option, because it has a greater chance of going out-of-the-money, whereas for an out-of-the-money option, a higher implied volatility will increase the delta, since it will have a greater probability of finishing in the money.
Implied volatility is not present volatility nor future volatility. It is simply the volatility calculated from the market price of the option premium. There is an indirect connection between historical volatility and implied volatility, in that historical volatility will have a large effect on the market price of the option premium, but the connection is only indirect; implied volatility is directly affected by the market price of the option premium, which, in turn, is influenced by historical volatility.
Implied volatility is the volatility that is implied by the current market price of the option premium. That implied volatility does not represent the actual volatility of the underlying asset can be seen more clearly by considering the following scenario: a trader wants to either buy or sell a large number of options on a particular underlying asset. A trader may want to sell because he needs the money; perhaps, it is a pension fund that needs to make payments on its pension obligations. Now, a large order will have a direct influence on the pricing of the option, but it would have no effect on the price of the underlying.
It is clear to see that the price change in the option premium is not effected by any changes in the volatility of the underlying asset, because the buy or sell orders are for the option itself, not for the underlying asset.
As a further illustration, the implied volatility for puts and calls and for option contracts with different strike prices or expiration dates that are all based on the same underlying asset will have different implied volatilities, because the different options will each have a different supply-demand equilibrium. This is what causes the volatility skew and volatility smile.
Thus, implied volatility is not a direct measure of the volatility of the underlying asset. Implied volatility varies with the change in the supply-demand equilibrium, which is why it measures the supply and demand for a particular option rather than the volatility of the underlying asset.
For instance, if a stock is expected to increase in price, then the demand for calls will exceed the demand for puts, so the calls will have a higher implied volatility, even though both the calls and the puts are based on the same underlying asset.
At the same time, the same fund managers may sell calls on the indexes to finance the purchase of puts on the same index; this spread is called a collar. This lowers the implied volatility on the calls while increasing the implied volatility for the puts. Because implied volatility measures the instantaneous demand-supply equilibrium, it can indicate that an option is either over- or under-priced relative to the other factors that determine the option premium, but only if implied volatility is not higher because of major news or because of an impending event, such as FDA approval for a drug or the results of an important court case.
Likewise, implied volatility may be low because the option is unlikely to go into the money by expiration. If implied volatility is high because of an impending event, then it will decline after the event, since the uncertainty of the event is removed; this rapid deflation of implied volatility is sometimes called a volatility crush.
However, implied volatility that is merely due to the normal statistical fluctuation of supply and demand for a particular option may be used to increase profits or decrease losses, especially for an option spread. If an option has high implied volatility, then it may contract later on, reducing the time value of the option premium in relation to the other price determinants; likewise, low implied volatility may have resulted from a temporary decline in demand or a temporary increase in supply that may revert to the average later.
So high implied volatility tends to decline, while low implied volatility tends to increase over the option lifetime. Thus, implied volatility may be an important consideration when setting up option spreads , where maximum profits and losses are determined by how much was paid for long options and how much was received for short options.
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