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Implied Volatility:
What, Why & How! 
Our cookie policy Options Trading  Jan 27, 2020  13

min read

By Punit Nandi



“When a long-term trend loses its

momentum, short-term volatility
tends to rise.” - George Soros
:
 

 Well, the quote sounds interesting and

captivating, but how do you know what is the
market’s expectation of volatility? Moreover, is
there a way to calculate future volatility which
would help us in taking long or short positions
in the options trading space? Sounds
intriguing, right!!

Well, we have got all your questions related to

“Implied Volatility in options trading” covered

in this article. The term used to characterize
expected market volatility from the date when
the option is bought till its expiry by market
participants is known as “Implied Volatility
(IV)”. But before we jump into the peculiar and
distinct characteristics of implied volatility, let’s
take a look into the sub-topics being covered
for this article.

Understanding Implied Volatility

Math behind IV
Calculating IV using python
Factors affecting the IV of an option
Uses of IV
Interpreting IV
:
 Trading Strategies using IV

Understanding Implied
Volatility

Before we dive into the basics of implied

volatility, you should be aware of the options
trading basics.

We will first start with a brief introduction of

volatility.

Volatility:

Volatility is one of the most important pillars in

financial markets. In simple words, volatility
refers to the upward and downward price
movements of a financial asset. The
movements are due to several factors
including demand and supply, sentiment,

corporate actions, greed, and fear, etc.

Now that we know what volatility is, let us now

understand what implied volatility really
means!!
:
 What is Implied Volatility?

Implied Volatility (IV) is the measure of

expected future volatility in the options
market. Essentially, implied volatility was and
is still considered to be an integral component
of the Black-Scholes-Merton model (a popular
option pricing model), where it represents
future volatility associated with the underlying
asset.

But, did you know that it is not the only

type of volatility measure available in the
market? Historical and realized volatility are
other different types of volatility measures in
the market.

Historical volatility

Historical volatility indicates the deviation or

change in prices of the underlying asset over
a given period of time in past. Usually,
historical volatility is calculated over a period
of one-year i.e. 252 trading days. It is used by
traders to compare the current volatility level
of an underlying asset with its historical
:
 volatility. Whenever there is a gap between
the current and historical volatility, traders
take positions based on the opportunity.
However, the issue with historical volatility is
that it is a backwards-looking indicator which
means it is based on the past returns and is
not the most reliable form of volatility.

Realized Volatility

Realized volatility, on the other hand, is the

actual volatility that will take place in the
future. For the volatility, that has taken place
in the past, it is known as historical volatility
and for the volatility that will take place in the
future, it is known as realized volatility.

So, why do we use implied volatility in the

options market?

The value of implied volatility has been

factored in after considering market

expectations. Market expectations may be

major market events, court rulings, top
management shuffle, etc. In essence, implied
volatility is a better way of estimating future
:
 volatility in comparison to historical volatility,
which is based only on past returns.

Math behind IV

We will now move forward and understand the

mathematics behind Implied Volatility and how
it is calculated for options.

Calculating IV is not an easy task as it might

appear to be. To calculate the Implied
Volatility of a call or put option, we first need
to understand the mathematics behind the
Black Scholes Merton(BSM) Model. As for the
purpose of this article, we will not dig down
much into the concept of the BSM Model but
we will definitely have an overview of what is

the BSM model so that the calculation of

Implied Volatility looks similar and easy to
understand.

Black Scholes Merton Model:

The Black-Scholes-Merton model is the most

popular option pricing model used by traders
when it comes to European options. It has two
:
 separate formulas for calculating the call
option and the put option.

The Parameters for calculating the call option

are :

St – Spot Price of the underlying asset

(Current Price)
K – Strike Price of the underlying asset

r – Risk-free rate(continuously
compounded)
σ – Volatility of returns of the underlying
asset
T-t – Time to maturity (in years)
N – Cumulative distribution function of
Normal Distribution

Pricing the call option :

Pricing the put option :

:
 Looks a bit complicated right? Don’t worry,
once you input the values of the parameters it
is just like any other simple equation.

For example: If the parameters are as follows

:

Spot Price (St): 300 Strike Price (K): 250 Risk-

free rate (r) = 5% Time to maturity (T-t) = 0.5
years (6 months) Call Price = 57.38

How do we find the implied volatility for the

call option with the parameters as mentioned
above? We will simply use the method of
reiteration or trial and error.

Using the IV of 15% fetches us a call option

price of 56.45 and using 25% gives us a call
price of 59.

It is clear from the above trial and error

method that the IV is a value between the
range of 15 - 25%. What about 20?. It gives
:
 us a call price of 57.38!! The same technique
can be used for put options accordingly. Once
you get hold of this technique, it's easy as pie!

Calculating IV using
python

Alright, now that we know the concept of

implied volatility, why not create a calculator
for calculating IV of an option? After all, the
knowledge earned should be applied
practically!!

We will create an implied volatility calculator

using python for easy calculation of IV for an
option.

The Python Code :

:
 ## Let us first import all the required libraries for IV
# Data manipulation
import numpy as np
import pandas as pd
import datetime
import mibian

# We will now use the mibian library to calculate the imp

##The syntax for the variable values is in the format as
# BS([UnderlyingPrice, StrikePrice, InterestRate, Daystoe

# Python code :
c = mibian.BS([145.65, 145, 5, 30], callPrice=3.89)

# Input Code :
c.impliedVolatility

Output for the input code :

18.24951171875

This means that the implied volatility for the

call option is 18.249% (approx)

Wasn’t that simple?! Python calculates a

complex mathematical model such as Black-
Scholes-Merton formula very quickly and
easily. This same mechanism can be used to
:
 calculate put option implied volatility.

Factors affecting Implied

Volatility in the market

Let’s take a look at certain factors that

influence implied volatility in options trading:

Supply and Demand - With the increase in

the demand for an underlying asset, the
implied volatility increases too and so does
the option price! Of course, this phenomenon
is exactly the opposite when the demand is
low. High IVs tend to move towards the mean
IV value with the fall in demand and the
supply starts stabilizing concurrently. This all
takes place once the market expectation
starts falling and leads to a reduction in the
option price.

Time to Expiration - Time to expiration,

better known as theta, which measures the
amount of time left for the option to expire,
affects the IV of an option directly. For
example, if the time to expiry is little, the IV
usually would be on the lower side. However,
:
 if the time for the expiration of an option is
relatively longer than usual, IV would be high.
Logically, it makes sense too! How? Since the
time to expiration is high, there is a lot more
chance that the underlying asset’s price might
move towards the strike price and that is too
risky for the option seller. To compensate for

the risk taken by the seller, the option price is

relatively higher than usual and so is the IV.

Market condition - Most underlying assets

are directly impacted by the market sentiment

or events that are to take place in the future

for a listed organisation. Earnings

announcement, court ruling, top management

shuffle, etc are some of the market events that

lead to high IV with an option as the market is

unsure of the direction that the underlying

asset might move.

Uses of IV

Implied Volatility is certainly used frequently in

the options market by traders for varied

reasons. Listed below are the various uses of

IV :
:
 To forecast volatility - Implied Volatility is

used by traders to understand the range of

expected volatility for an underlying asset. For

example, let us consider a call option with an

underlying asset currently trading at $100, the

strike price at $103 and the premium at $5. If

the Implied volatility is 20% for such a call

option, the expected range for the underlying

asset is 20% above the current trade price

and 20% below the current trade price. This

tells us that the lower bound would be at 100 -

20% of 100 = 100 - 20 = 80. The upper bound

at 100 + 20% of 100 = 100 + 20 = 120. The

range of the implied volatility in such a case

would be from 80 - 120.

To hedge cash position - A trader frequently

needs to hedge a position to reduce the risk

associated with the initial or primary position.

If the current IV of an option is comparatively

lower than the annualized IV or the IV for the

entire year, a trader can buy options at a low

premium and wait until the IV increases. With

the increase in IV, the value of the option

premium rises too and thereby the total value

of the option contract jumps up!

:
 To write options - Contrary to hedging,
option writers (option sellers) sell options

when the IV is high and thereby pocket high

premiums for the risk they are undertaking.

The catch here is that for the insurance

(option) they are selling, time to expiration

keeps decreasing. After a considerable time

period has elapsed, the trade moves into the

favour of the option seller.

Event-based trading - Whenever there is

news relating to earnings or court ruling

pending for a listed organization, the IV is

usually high. This happens when the future is

likely to be uncertain. In such a scenario,

informed or experienced traders do create

option strategies revolving around implied

volatility. For example, traders use calendar

spread strategy, bull or bear spread strategy

to benefit from high IV.

Usage in Black -Scholes-Merton (BSM)

Model: Implied Volatility is a key parameter

when it comes to BSM Model. As the implied

volatility or the market expectation about the

volatility increases, the option price increases.
:
 This creates a direct relationship between
implied volatility and the option price. IV,

therefore, forms an intrinsic property of the

Black Scholes Merton Model.

Interpreting IV

There is more than one way to visualize and

interpret implied volatility and we will look at

each one of them specifically.

Data Table - Well, the most basic way to

visualize IV numbers would be through a data

table format. Now, in the options market, it is

known as an option chain. Below is an Option

Chain for the US Stock: Apple (ticker: AAPL)

Source: Investing.com ( Note: Options data

is updated each day, so you will be able to
:
 see the current’s day option prices on the

given link)

From the above image, it is very clear that the

Implied Volatility for the same strike price is

different for call and put options. Also, for

different strike prices, the Implied Volatility

fluctuates with the shift in market

expectations. Note: Implied Volatility is not a

direction based parameter and therefore it

only indicates the range of prices an

underlying asset might move in the future.

This change in implied volatility in both the put

and call option at different strike prices is

characterized by "Volatility Smile" and

Volatility Skew. Volatility Smile takes place

when the implied volatility(IV) is the highest at

OTM and ITM call or put options with the

lowest at, ATM option. In the case of Volatility

Skew, different strike prices have different

implied volatility for the same underlying

asset.

Both interpretations are used in the options

market for better visualization purposes.

Below, we have mentioned the Volatility Skew
:
 example from the call option strike prices and

implied volatility relatively.

Chart - Alright, now that we have understood

and interpreted implied volatility from an

options chain data table, we will visualize

implied volatility through a chart and interpret

IV levels from the same.

Source: IVolatility.com
:
 In the chart, we have the implied as well as
30-Day historical volatility data for the past

one year.

Market participants, use historical implied

volatility levels to gauge an understanding of

where the IV, say, for example, was at 3

months ago and at what level it is today for

trading based on the opportunity.

Traders also use past trends of both historical

and implied volatility to understand if the HV

and IV together are higher or lower than

previous periods. If you start trading options

today, this is your go-to tool for gauging

implied volatility levels. As stated earlier, there

are a number of factors why the implied

volatility level is high or low at a certain point

in time.

Implied Volatility (IV) Rank - IV Rank is

another popular way of calculating the implied

volatility over the last one year or 52 weeks. It

is calculated for figuring out how high or low

the current IV level is when compared with the

annualized levels. There is a particular

:
 formula to calculate IV Rank which is
mentioned below:

(Current IV - 52 weeks low IV / 52 week high

IV - 52 weeks low IV) * 100

For Example: Let’s consider the example of

Apple (ticker: AAPL) which was mentioned in

the chart section of IV. The current IV is at

32.5%, 52 week low IV is 18%. 52 week high

IV is 34%. So let’s do the math :

32.5% - 18% / 34% - 18% = 14.5% / 16% =

90.625%.

Interpreting the IV Rank is easy too. Intuitively

IV rank refers to the difference between the

Current IV and 52 week low IV i. In this case,

it is 90.625%. This means that the IV is

currently higher than usual and a trader would

be interested in selling the options due to high

IV. High IV means high option price and thus

would benefit the option sellers heavily. Option

buyers who buy options with high IV face

losses due to the decrease in IV at a later

point in time.
:
 Implied Volatility (IV) Percentile - IV
Percentile is another interesting way to look at

IV or to interpret it. IV Percentile simply refers

to the number of days the current IV is under

the current IV percentage value as compared

to the total number of trading days .i.e. 252

trading days

IV Percentile = Number of trading days under

current IV / Number of trading days in a year.

For example: If the number of days under the

current IV (30%) is 100. The number of

trading days is 252. IV Percentile = 100/252 =

39.68 percentile (approx).

Below is a data table of Indian Stocks dated

for the 26th of November, 2019 with their IV

Rank and IV Percentile for visualizing IVR and

IVP!

Symbol IV IV Implied
Rank Percentile Volatility

TATACOMM 86.99 98.47

:
 SUZLON 93.17 98.54 184.13

NATIONALUM 73.74 96.65

CGPOWER 81.12 96.4 106.29

BOSCHLTD 78.16 87.94

RAYMOND 71.63 95.43

IDEA 73.04 96.27 167.51

NBCC 72.05 98.74

IRB 71.43 93.53

TV18BRDCST 97.1 97.84

JETAIRWAYS 100 100 483.73

Let’s us deduce the concept of IVP with

:
 relation to Implied Volatility with an example of

two equity stocks i.e. Tata Communications

Limited (TATACOMM) and Suzlon Energy

Ltd(SUZLON). TATACOMM has an Implied

Volatility(IV) of 48.2 % whereas SUZLON has

an Implied Volatility of 184.13%. Given that

there is a huge gap between the IVs of both

the equity stock options, to the logical mind, it

looks like the IVP should have a huge

difference too. However, in reality, the IVP of

TATACOMM is 98.47 and for SUZLON, it is

98.54, which makes a difference of only 0.07

percentile!

This means that even if the IV of TATACOMM

was at 48.2%, it was still trading at one of its

highest levels similar to SUZLON. Therefore,

before trading options using IV, one should be

aware as to what has been the historical IV

values for an option and where it stands

currently. This is exactly where the application

of Implied Volatility Percentile becomes

crucial, where it helps us in identifying current

IV values in comparison to where the IV has

been over the past one year ( 252 trading

days).
:
 Historical IV vs Realized Volatility -
Historically, IV has a trend of mostly being

more than the realized volatility. Market

expectations keep fluctuating which means

that they are always either more or less than

the realized volatility value of the underlying

asset. In the below example, we show the

Dow Jones Index’s comparison between

Implied Volatility and realized volatility

(volatility that actually took place) to visualize

the same concept. The Blue line represents

realized volatility and the yellow line

represents implied volatility. Implied Volatility

is mostly above the realized volatility due to
fluctuation in market expectations.

Trading Strategies using

IV

Given that there is a positive relationship

between implied volatility and price of an

:
 option, traders use implied volatility as a key
parameter for their strategies. This may
include basic options strategies like bull

spread, bear spread and covered call

strategy. Usage of implied volatility can also
be seen in trading strategies using forward
volatility or while pricing options. Also,

advanced options strategies like the iron

condor and modified butterfly strategies
involve the use of implied volatility.

Conclusion

Finally, we have come to the end of this

article. We learned about the concept of

Implied Volatility, why it is used and how it is
used in options trading. We understood the
Black - Scholes-Merton model and learned

how to calculate IV by reiterating the formula.

We also learned how to calculate IV using
python. All in all, now that you know about
implied volatility, you are aware of the

importance that IV as a parameter in options

trading carries. However, since options trading
requires risk management and perfect
strategy execution mindset, knowledge
:
 learned from this article can be utilized as a

complementary tool while trading options!

Disclaimer: All investments and trading in the stock market

involve risk. Any decisions to place trades in the financial

markets, including trading in stock or options or other

financial instruments is a personal decision that should only

be made after thorough research, including a personal risk

and financial assessment and the engagement of

professional assistance to the extent you believe necessary.

The trading strategies or related information mentioned in

this article is for informational purposes only.

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May 24, 2019

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