Implied Volatility

As many of you know, I’ve been spending much of my time lately trading stocks and options. It’s been quite an adventure – I went from being a buy-and-holder starting in the mid-90′s, to a day trader who thinks of a long-term position as something I hold over lunch. :-)

The longer-term positions I do hold are usually option positions. Over the last year or so, I’ve been learning the ins and outs of option trading; the greeks, the vix, implied volatility, all of that. I remember one of the first articles I read about the greeks – all I could think was, how am I supposed to remember all this? But as time goes on, things all started becoming more clear.

Except, of course, for this concept of implied volatility.

Now, just like everybody else, I read that there’s this thing called the Black-Scholes model for option pricing, and you plug in a bunch of stuff and out comes the price of the option. Most of what goes into that calculation (or one of the other options pricing models) are facts – the current stock price, time to expiration, etc. But part of what goes into that is this notion of expected, or implied, volatility.

Hmm. At first glance one would assume this implied volatility has something to do with the historical volatility. While that’s partially true in most cases, it’s not a good assumption.

augen1.jpgAnd then finally, out of the blue, it all clicked. I was reading The Volatility Edge in Options Trading by Jeff Augen, which is a fantastic (but definitely non-beginner) book which discusses some statistical approaches to option trading. And somewhere in this book, it all suddenly became clear.

At a given moment in time, where all other things are equal (so all other variables are fixed), the price of an option is related to its implied volatility (IV). If IV goes up, the price goes up.  Ok, great. Didn’t need a long blog post for that.

But you can also think of it the other way. If price goes up, IV goes up. And make no mistake – fancy equations aside, options are priced based on supply and demand.

IV isn’t something magical that’s calculated by “them”, and foisted on the rest of us. Rather, one can think of it as a way to express how much premium exists in an option. If an option is trading on the offer, you’ll see IV higher than if it’s trading on the bid, because the transaction price is higher.  If you buy enough of them to drive up the price, that will manifest as a higher IV.  And in the last few hours of option trading on expiration Friday, when there’s technically still a day to expiration (equity options technically expire on Saturday), you’ll see the IV drop to nearly zero in order for the option price to drop to its intrinsic value.

I’m sure many will argue, and most won’t care…but this was really the last piece of the way options are priced to “click” for me. So I wanted to write it down, in the hopes of helping someone else get through it all a little more easily.

6 thoughts on “Implied Volatility

  1. Tom

    That’s it! I am totally ready to make a killing in the market with this last piece of knowledge. Thanks Greg!

    Can I, um, borrow $10,000 to get started?

    ;)

    (good luck with the market wizardry dude!)

    Reply
  2. Paul Redfern

    I read in one of your earlier blog posts that you play poker. So my question is, Do you feel like you have more of an edge when you sit down playing poker or when your trading stocks and options?

    Both are a form of gambling and Id be interested to hear your thoughts on how you differentiate the two. In my opinion both can be beatable but need a lot of time studying, working on strategies etc..

    Reply
  3. gregr Post author

    Paul, interesting question.

    In poker, there is the matter of making plays where your expectation exceeds the risk; added to this is analyzing the other players (getting a “read”) and determining how that affects your probabilities.

    For trading, I’m much more of a newbie I think (at least in terms of day trading stocks). But in a sense, it’s also about finding plays that have at least a certain probability of winning, and executing them with a certain amount of risk where you have a positive expectation.

    I’ll give it some more thought…I’m intrigued by the similarities between them.

    Reply
  4. Paul Redfern

    Thanks Greg. It is intriguing when you compare both. I have a degree in Economics but long since been used and my knowledge of day trading has been forgotten. But could you compare trend trading on financial markets to this situation in poker.

    Your opponent to your direct right folds to a 3bet every time he is the open raiser on the button. Therefore you keep 3betting him in this spot until he starts to adjust to the situation. Depending on the skill level of the opponent this might be never or relatively quickly. This is similar to trend trading as we will continue to use this profitable play until he starts to 4 bet us or defend by calling our 3bets and floating on the flop.

    Once this occurs this profitable ‘trend’ ceases to exist, so we alter our strategy now to exploit his new trend or adjustment..

    Reply

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