What is implied volatility and how do you use it?

What is implied volatility?

According to the CFA institute, implied volatility is a measure of the expected risk with regards to the underlying for an option. The measure reflects the market’s view on the likelihood of movements in prices for the underlying, having the tendency to increase when prices decline and thus reflecting the riskier picture. Given this predictive nature, implied volatility serves as a useful tool in gauging the overall market condition and provides guidance for trading.

As the term ‘implied’ suggests, it is the implicit or expected future likelihood of the volatility we are projecting as compared to historical volatility. This can also make the reading relatively subjective and not a hundred percent accurate all the time. Do note that although implied volatility, measured as a percentage, which typically surges with sharp declines in prices and decreases as prices retrace losses, it is truly directionless.

Implied volatility is commonly used by the market to pre-empt future movements of the underlying. High volatility suggests large price swings, while muted volatility could mean that the price fluctuations may be very much contained.

It is also commonly used in the pricing of options, which as we know may become in the money (ITM) with high volatility, should the volatility help prices breach the strike price in the favourable direction. As such, options with high implied volatility tend to come with higher premiums.

How to calculate implied volatility

Compared to various trading indicators, the computation of implied volatility may not be as straightforward. Implied volatility can be derived in the Black-Scholes model using various inputs. As Investopedia had put it simply, the factors are as follows:

1. The market price of the option
2. The underlying stock price
3. The strike price
4. The time to expiration
5. The risk-free interest rate

From here, you can see that the factors are items that reflect the present situation of the underlying as compared to using historical properties of the underlying to compute an expectation for a future outcome.

Implied volatility vs historical volatility

As told above, implied volatility and historical volatility are two very different items and it is worth highlighting the differences of the two frequently used volatilities for options trading.

Historical volatility refers to the volatility derived from the security’s price movements in the past. In comparison, implied volatility is forward looking. At this current point of time, historical volatility can tell you about how price had fluctuated in the past. However, if you want to have some form of a guide on how prices are expected to fluctuate in the future, it will be implied volatility that must be utilized as it reflects the market’s current view and is forward-looking in nature.

Trading implied volatility with VIX

Given the use of implied volatility in pricing options, it will be an important one to watch when it comes to trading options. That said, implied volatility itself can also be traded.

One popular measure of implied volatility, or forward-looking volatility, is the CBOE Volatility Index (VIX) for the comprehensive S&P 500 index. Commonly known also as the ‘fear gauge’, the VIX reflects the equity market’s forward-looking volatility in the next 30 days.

As told, implied volatility typically surges with sharp declines in prices and this can be seen through the chart below which shows the VIX being inversely proportional to the S&P 500 index. Given that sharp drops in the stock market typically unfolds suddenly while gains of a similar level usually take a much longer time, this likewise finds sharp spikes for the VIX followed by a slow fading of its strength. Using the reference point of approximately 20 for the historical average of the VIX, one would note that with any surge above 20 on the IG volatility index chart, prices tend to edge lower thereafter. This can make for one trading strategy underpinned by the typical behaviour of the stock market.

More intuitively, however, one may also look to the implied volatility as a guide to go long or short in the market.

Since spikes in implied volatility typically unfold suddenly, the decline following a sharp increase may instead be a good indication for going long in the underlying. In the example of the VIX, the slide of the index past 20 over 2018 and 2019 had been followed by rallies of the S&P 500 index.

Risks may nevertheless lurk in this case which is why placing a guaranteed stop can ensure you are able to better manage your risks and returns particularly in the situation of market dislocations.

Read more about other volatility trading strategies here