What Is Implied Volatility In Options Trading?- How Does It Affect?

Options trading is one of the most famous investment strategies due to its ability to profit in different market scenarios. There are several factors that influence the price of an options contract, and one among them is implied Volatility. The implied Volatility represents the expectation and sentiments of the market. It can greatly impact the pricing of the options and strategies implemented. Thus, in this article, we shall see the meaning of Implied Volatility and how it affects the options trading process.

Understanding the concept of Implied Volatility

Implied Volatility is the measure to know the market's perception of the future. It shows the price fluctuations in the underlying asset. The implied Volatility is a very important component in determining the option contracts price. How to get this implied Volatility? So, first thing IV is not visible directly, but traders can derive it by applying various mathematical and statistical methods and models.

One of the well-known methods to derive the Implied Volatility of any stock is given by Myron Scholes and Fischer Black, known as the Black-Scholes method. It considers some inputs such as risk-free interest rate, the underlying asset's current price, the contract's expiry time, and the strike price; putting them all in the formula, traders can get the value of Implied Volatility. 

The Impact of Volatility on the Options Pricing 

The implied Volatility and the price of the options are directly related to each other. When the traders expect higher price fluctuations in the market, the IV increases, and so do the options premiums. On the other hand, when there are fewer fluctuations, it implies low Volatility, and thus the low options premium price. When there is high Volatility, it also means that the market is heavily uncertain, the market is observing heavy price swings, and it may lead to either huge potential profits or losses for the traders involved.

Let us see how implied Volatility affects the option trading strategies:

Implied Volatility plays a significant role in deciding which strategies to apply. Find below the major ways IV affects the trading-related decisions of the traders. 

While buying the options 

• Traders tend to buy those options contracts that they expect will experience high price movements in the asset in the future.
• High IV also implies high options premiums.
• Therefore, traders are more interested in those stocks that are currently stable and will experience high Volatility in the future.

While selling the options

• The impact of IV is also seen while selling the options contracts, using the various option trading strategies such as writing covered calls or cash-secured puts, etc.
• However, high Volatility increases the option's premium price, leading to a profit scenario for the sellers.
• But it also comes with a high risk, as the wings may be very high.

While doing Volatility Trading

• Some traders specialize in volatility trading; they take advantage of fluctuating prices of the underlying stocks by implementing various complex options strategies and capitalizing on them.
• They implement an options spread strategy.
• The profit is made by the expected volatility shifts, regardless of whether the price goes up or down.

As we saw that Implied Volatility is crucial in determining the options pricing, how can we get the details about it? The answer is very simple, using the IV screener. The Implied Volatility screener is the tool at the service to the traders that help them find the Implied volatility rate of the selected stock in the market.

These implied volatility rates get influenced by factors such as overall market sentiment, economic news, major announcements, geopolitical changes, etc. Traders will observe a rise in Volatility due to any of the above events, and it will be steady when the market is stable.

Let us see in detail what are those factors that can influence Volatility:

• Overall market sentiment:

For some options traders, market sentiments are crucial in deciding the IV. when the traders feel less risk and are positive about the market, the IV is low and stable. On the other hand, when people are pessimistic about the market and trade cautiously, it increases uncertainty, leading to a high IV in the market.

• Any major news or events:

Any big news to be aired, such as GDP, employment data, bank announcements, or geopolitical events, can impact the volatility rate heavily. Any unexpected news may create chaos in the traders and lead to sudden and high Volatility. Traders monitor their calendars for any such events and related news to predict the volatility spikes and trade accordingly.

• Announcement related to earnings:

When the company decides to make an announcement regarding any stocks, the IV increases in the market with each passing day of the announcement. Based on the company's financial performance, traders anticipate high or low swings in options pricing. The high Volatility suggests that the traders are not sure and are afraid of the results, and therefore there is huge chaos. At the same time, the stability in IV symbolizes that the company's results are good, and traders are expecting good news.

• The concept of supply and demand:

The concept of supply and demand can also largely affect the volatility rate of the underlying asset in the market. Suppose there is a sudden demand for X commodity or a shortage of Y commodity in the market, which may lead to high price fluctuations. Opposite to that, when there is an oversupply of any commodity, it may lead to low IV.  

• Expiry time

IV can also be affected by the expiry time of the options contract; as the expiry of the contract approaches, the IV  is generally high, and as and when the cloud of uncertainties gets cleared, the high IV diminishes.

Every trader must consider that the IV is ever-changing with new information and under various market conditions. Traders must keep themselves updated by using the IV screeners and monitoring the factors influencing the IV to adjust their strategy and make further informed decisions. It will help them to capitalize on the potential opportunity and mitigate the risk.

Conclusion

So, we have seen in this article what implied Volatility is, how it can get affected, and how options strategies get affected via various factors. Therefore, keep an eye on those factors, use an Implied Volatility Screener to check the IV rate of your stocks, and try to stay ahead in the market.