Options Strategies based on Implied Volatility

Understanding Volatility of Commodity or Stock Options is the key to achieving success in using options strategies for hedging and in general for making the most of your investments. In this post I will try to describe all important aspects of volatility that in my opinion every investor must be aware of. What will come out of the analysis presented below is a beautiful options strategy to predict the stock market using the stock market itself !. Investors who write and buy options purely for speculative reasons cannot afford to miss the analysis and options strategy given below.

I will assume that you are familiar with the basic language of call options and put options and you know terms like what is options premium and the underlying. If you are new to options trading and options strategies, read my post on Options trading examples before you proceed. You may also like to read my post on Covered Call - Options Strategy.

One of the most important factors which influences the 'time premium' part of Options is Volatility of the Underlying (stock or commodity or index). Roughly speaking volatility is the measure of how much the underlying moves. For examples, if the average daily movement (up or down) of a stock is say 1%, then the daily volatility of the stock is 1%. The volatility is usually measured on an annual basis. That is the average movement of the underlying (based on historic values) in one year. Here is a quick formula relating daily volatility to annualized volatility.

Daily Volatility x 16 = Annualized Volatility

16 is the square root of 256 which is approximately equal to the number of trading days in a given year. In general you multiply the daily volatility with square root of 'n' to obtain volatility (or average expected movement, up or down) for 'n' number of days.

What is implied volatility?
Here is the key fact: The value of volatility of the underlying used to calculate the options price is based on historical values. However this theoretical value of options premium may not be equal to the exact value of the price of options traded in the market. The reason for this is explained in the following options volatility example:
Suppose you are buying a call option on a stock which has a historic value of annualized volatility of say 20%. Now, the situation is such that a sudden upward movement is expected in the price of that stock. For example, this could be due to unconfirmed news of acquisition of that particular company. In this case, you know that the actual movement expected in the stock price in the next few days will be more than the average historic up-down movements that the stock has shown. In other words, the 'expected volatility' also called as 'implied volatility' is more than the theoretical value of volatility calculated based on historic values.
Options premium or options price can be calculated using volatility and other parameters like expiry date of the option, etc. Similarly, if you know the current market price of an option, you can calculate implied volatility using the current option price and other parameters like days remaining for expiry, and the strike price of the option.

Using implied volatility to predict price movements and designing Option strategies
Here is a simple options strategy based on the concept of implied volatility which you can refine slowly and fine tune to your own experience. For the sake of illustration, I will discuss strategy based on index options but exactly the same options strategy could be used for stock options or commodity options. Let us assume we are dealing with an index (like Dow Jones or Nifty or any other) whose annualized volatility is 25%.
  1. The annualized volatility is based on historic values of the movements of the index. Now make a list of 5 most active call options based on that index. Similarly make a list of 5 most active put options.
  2. Now for each of the 10 index options above (5 call and 5 put) calculate the implied volatility of the index.
  3. Calculate the average implied volatility for call options and the average implied volatility for the put options.
Now by comparing the implied volatilities with the theoretical value of volatility calculated using the historic values. Now by looking at the implied volatilities you can make decisions about your options strategies by using the table below.

Implied Volatility values
Conclusion
Average Implied volatility of call option is greater than average implied volatility of put option.
This means that an upward movement is more likely than a downward movement. You can then use a suitable options strategy like writing a covered call or simply buying a call option or buying options to create a suitable option spread.
Average implied volatility of call and put option is roughly same and is greater than the theoretical value of volatility.
This means the market is more volatile than usual. You must be careful before making any investments in such a market. Using Options strategies as a hedge against your other stock market investments is best in this situation. E.g. if you have significant investments in stocks, it is best to buy a put option. Or depending on your risk appetite you can book some profit to avoid any risk. Buying a Call and Put at the same time may also be a profitable strategy to take advantage of any sharp movements.

To be honest, I have only given a small indication of how implied volatility can be used to design your option strategies. The above can be refined a lot by taking into consideration option interest of options or even change in option interest. Subscribe to this blog feed if you would like to read further posts on options strategies and especially refinements of the simple option strategy given above.

Options Greeks

  • Option Greeks for Beginners (with free Options Calculator)
  • Option Greek Delta and Delta Neutral Options Trading Strategy
  • Option Greek Theta and its role in Options Trading Strategies
  • Option Greek Vega and implied volatility
  • Option Greek Rho - does it really matter in your Options Trading Strategies?
  • Stock Market Derivatives: Futures, Options

  • From Forward contract to Futures.
  • Stock Futures example - Futures trading basics explained.
  • Stock Options trading examples - Call Option Example and Put Option example.
  • Covered Call and Covered Put - Simplest Options trading strategy.
  • Volatility and Options Pricing - How is Option premium priced?
  • Lot Size of a Derivatives Contract - Contract Unit

  • Options Trading Basics
    In the Money Stock Options
    At the Money Stock Options
    Out of the Money Stock Options

    May 8, 2009

    1 comments:

    Harish Ramachandran November 6, 2010 at 3:37 PM  

    hi... i am a student pursuing my MBA in finance and i want to do a project in option greeks. i have read up on the greeks but i wish to know how can they be used to enter into a strategy?
    how should we read them in conjunction with the market sentiment, the volatility so as to decide upon an option trading strategy?

    i have last 10 years daily data of the NSE and i have computed the greeks for each of the daily data.

    what are the studies that i can do empirically...

    i will be grateful if you share with me your practical wisdom.
    my email id is harishr27@gmail.com

    thanking you yours sincerely,
    harish

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