In the futures and options markets, volatility is a primary concern of every participant. No matter what you’re trading―whether it’s stocks or soybeans―understanding when, why, and how the market moves is vital to success. Although options are unique financial instruments, volatility must be accounted for. If not, risk increases exponentially while opportunity is often squandered.
Read on to learn more about how implied volatility influences options pricing, strategies, and profitability.
What Is Implied Volatility?
Within the context of the capital markets, volatility is the periodic fluctuation of asset pricing. It is a product of price discovery and the evolving dialogue between buyers and sellers. As a general rule, the greater a market’s volatility, the greater the assumed risks and potential rewards.
When evaluating price action, you can view volatility in two ways:
- Historical (HV): Historical volatility is a statistical representation of a security’s highs and lows over a given period of time. HV is typically measured in terms of standard deviations with respect to a mean value. As HV grows, so do risk and reward.
- Implied (IV): Implied volatility is a metric used to forecast the probability of forthcoming fluctuations in asset pricing. Relative to options trading, traders use IV to evaluate contract premiums. Essentially, the greater an option contract’s IV, the more expensive its premium.
For options traders, IV is the key to accurately valuing contracts. One of the industry-standard tools for accomplishing this task is the Black-Scholes Model (BSM). Conceived in 1973 by economists Fischer Black and Myron Scholes with later input from Robert Merton, BSM is an equation used to quantify option value with respect to implied volatility.
Functionally, the BSM takes the contract’s time until expiration, strike price, underlying asset price, and risk-free rate to calculate its IV. An option’s IV is a powerful tool for comparing contract premiums and crafting strong trading decisions.
If you’ve ever traded options, then you are aware of the complexities surrounding contract pricing. An option contract’s premium is a function of its strike price, the underlying asset’s price, and time to expiration. Weighing these factors in live market conditions is, at the very least, a challenge. Fortunately, implied volatility gives traders a way to determine a contract’s relative value.
To illustrate this functionality, assume that the market for CME September corn (ZC) has just broken out to the bull. Accordingly, a high volume of traders become interested in this market’s topside potential. September corn options are now seeing rising premiums as speculators pile into the market buying at-the-money (ATM) and out-of-the-money (OTM) calls. The increased order flow “bids up” the September corn options chain as the public is hoping to capitalize on higher corn prices. If they are correct, solid profits will be locked in above various strike prices.
Of course, there’s a flip side to that coin. Although corn’s robust IV is attractive to call buyers, the market dynamic can quickly change. In the event that corn prices pull back, IV will drop rapidly, negatively impacting the value (premiums) of purchased calls.
This sets off a chain reaction as speculators liquidate (sell) their positions to minimize losses. The result of the pullback is a swift drop in the value of corn options and the trading account balance—results that frequently leave market newbies in shock.
Boost Your Options IQ Before You Dive into the Market
A word to the wise: If you’re going to trade options during periods of high volatility, be sure to manage risk prudently. Fortunately, you have many ways of doing just that, including vertical spreads and advanced delta neutral strategies.
To learn more about options and implied volatility, reach out to a market professional at Daniels Trading. Our team of brokers has the support, service, and pricing you need to make your options trading venture a success.