How to interpret implied volatility in options
What is implied volatility?
Implied volatility (IV) of an option contract represents a trader's perception of near-term risk in the underlying index or stock.
It is a one of the key factors that decide an option's price, which usually rises in times of high volatility. The implied volatility of an option at any point of time is derived from its last traded price.
How is it tracked?
An option buyer pays a premium that is linked to the volatility expected in the market. In transactions involving an illiquid option, counterparties negotiate on implied volatility rather than just the price.
Analysts also track IVs as an indicator of broad market sentiment. Each contract has a unique IV, which is displayed on terminals and exchange sites.
Analysts generally track IVs of at-the-money (ATM) Nifty options - those with strike prices nearest to the spot.
(Posted date - 24 July 2012)
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What do its values imply?
When traders are pessimistic, they tend to buy put options as protection. This increases the IV of puts, signaling bearishness.
Similarly, when traders are not aggressively protecting themselves from sharp market movements, IVs drop.
Most traders are comfortable with IVs between 20% and 25%. Recently, IVs of ATM Nifty options have fallen to around 14%, because traders are not expecting any events that can cause volatility.
Do high IVs always imply bearishness?
Theoretically, implied volatility readings do not signal market direction and hence do not necessarily indicate bearishness.
However, traders usually take high IVs as a bearish signal. They argue that more often than not, expectation of a downfall has a stronger impact on trading behaviour, than hopes of an upside.
So high IVs are usually a result of bearishness as investors and fund managers rush to protect themselves from a sharp downside.
How do traders profit from volatility?
When IVs are low, options are cheap and derivatives traders use so-called 'long vol' strategies to profit from a rise in volatility.
A typical trade in such a strategy is a 'long strangle', where traders buy Nifty call and put options where the put option is of a lower strike price.
The trade profits from a sharp movement in Nifty - whether up or down. Thus, it captures the increased volatility in the Nifty without betting on the direction.
Vol trading is very popular among institutional and proprietary traders. However, these traders benefit from expectations of big moves in the market ahead.
In fact, some analysts believe that prolonged spells of low IVs mean that these vol traders are not anticipating any big moves and are instead expecting the options to expire worthless.