Implied volatility is the forecast of a likely movement in the underlying. Keeping it simple, implied volatility is how options are priced. When IV is higher, option prices are higher and vice versa. Generally, when the market moves lower, option prices and IV increase as demand goes higher for protection or a hedge. When the market is steady or moving higher, generally IV levels and option prices are lower.
Implied volatility is analyzed using a volatility chart. A volatility chart tracks the implied volatility and historical volatility over time in graphical form. It is a helpful guide that makes it easy to compare implied volatility and historical volatility.
The greek vega changes option premium based on changes in implied volatility. Keeping it simple yet again, for every 1% change in IV, vega will increase or decrease option premium by that amount. An increase in IV has vega increasing the premium and vice versa. Below we will take a closer look.
Implied Volatility When You Buy and Sell an Option
When you buy an option, you have positive vega. An increase in IV in which vega would increase the premium is beneficial. When you sell an option, you have negative vega. A decrease in IV in which vega would decrease the premium is beneficial. The same is true of a spread. If the long option vega is greater than the short position vega, the position has positive vega and vice versa. The bottom line is when you have positive vega overall, an increase in IV is desired; and when you have negative vega overall, a decrease is beneficial regardless of the option strategy. Let’s take a look at one below.
Bull Call Spread – Long Leg
A bull call spread is when a trader buys one call and sells another that has a higher strike price with the same expiration. The long call would have positive vega and an increase in IV for that option would be beneficial for the position.
Bull Call Spread – Short Leg
The short call would have negative vega and a decrease in IV for that option would be beneficial for the position. In addition, if the IV for the long option is lower than the IV for the short option, the cost of the spread would be less than is they were even or the IV was higher for the long call. This would be an advantage because the risk and cost would be lowered and the max profit would be greater too.
How Does the VIX Affect Implied Volatility?
The VIX Index measures the 30-day expected volatility of the stock market derived from the prices of the S&P 500 Index call and put options. It is probably the most recognized measure of volatility. Take a look at the VIX chart below.
Now take a look at the S&P 500 ETF (SPY) for the same period below.
For the most part, when the SPY moved higher, the VIX moved lower or stayed steady; and when the SPY moved lower, the VIX moved higher and returned lower after the SPY rallied higher again. Basically, when the market falls, options prices and the VIX increase; and when the market moves higher or stay steady, option prices and the VIX tend to fall or remain steady.
Implied Volatility Examples
Coming back to the bull call spread example from above, here is a recent option chain for AMC Entertainment Holdings Inc. (AMC). A Sep-17 45/50 bull call spread was looked at below.
Notice the IV for the long 45 call is 136.6% and the IV for the short 50 call is 150.2%. A cheaper call is being bought than sold. The cost of the trade currently is 2.00 (5.55 – 3.55), which gives the trade a max profit of 3.00 (5 (Diff in the strikes) – 2 (cost)) if the stock is trading at or above $50 at expiration. Because of the favorable IV skew, the risk/reward is improved. The breakeven for the this spread at expiration is $47 (45 + 2). Partially due to the favorable IV skew, the stock is trading above that level ($47.64) at the time of this screenshot.
Knowing how to read IV levels, take advantage of IV skews and forecast what IV will do in the future can be huge advantages for an option trader. The fact is, just knowing how to minimize the effect of IV when applicable can make a difference between a winning and losing option trade.
Senior Options Instructor
Market Taker Mentoring, Inc.