Implied Volatility: Why does it change?

BY MARK D WOLFINGER ON 01/10/2011

I recently received the following e-mail question It's fairly simple, but on further
analysis I find it most disturbing:
Is it possible to find out who changed IV and why and for how long?
Here's the background: Last week I posted a discussion based on a readers
question about an iron condor position that immediately lost money (it's worth
reading as background for today's post). Because he expected to collect theta
every day especially when the underlying asset did not undergo a large move.
Basically, he didn't understand how this loss could have happened. The question
above is the result of my telling him that the implied volatility of the options had
increased.
In other words, he was trading iron condors as if they were money in the bank.
An increase in IV took him by surprise, prompting today's questions: Who is
responsible for the higher IV? Why was it changed? How long will it last?
Every question deserves an answer, especially when an explanation may turn
into an 'aha moment' for the questioner. What truly disturbs me about this
innocent-looking question is that it demonstrates a complete lack of
understanding of how the markets work.
When playing a game or when practicing some trade ideas with play money, there
is no question that's out of line. There are two types of trader who use papermoney accounts:

The beginner who is trying to gain an understanding of how to trade and

what has to be learned

The expert who is fine-tuning strategies, looking for any additional small
edge
The beginner is expected to be learning as he/she goes. Reading, taking
classes, attending webinars and asking questions. I'oveheard very

unsophisticated questions and that's to be expected. But the questioners learn

from the answers and move beyond the basics.
Today's question comes from someone who is using real money (although I don't
know the size of his positions). This single set of question tells me that he is not
yet ready to trade. The whole concept of options trading, options markets, how
prices are determined and what options are worth has not yet been grasped.
There's nothing wrong with that when using play money.
It's fun to win and there's no harm done whe losing money. Asthe trader plays,
he/she gains playing experience, and insight into some subtle strategies tha had
not yet considered, etc. That's how one becomes a better player at chess,
monopoly, backgammon, or any other game. As long as you are not playing for
money and the game is taken seriously by the participants, it's a good learning
experience for everyone.
However, when trading with real moneyy, some elements of the game change.
There is the possibility of earning some serious cash, and that's fantastic. There
is also the chance of losing far more than the player realizes is at stake, and that
can be devastating. Trading is not a game and one must have some basic
understanding of the rules of engagement and in this case, it's a basic idea of
how the markets work.
In the previous post, I explained that his trade is losing money because his
negative vega position is being hurt by a rise in the implied volatility of the
options in his position.

Who changed IV? Why?

No one individual changed the implied volatility of AAPL options. Many
thousands of contracts trade every day, and if anyone tried to bid prices higher or
offer them at steadily lower prices, that person would be stampeded by everyone
else in the marketplace who thought he was wrong-headed in his efforts.
It takes much more than a single 'who' to 'change IV. Changes occur for basic
reasons, and subtle factors make a difference.

Supply and demand is often 'blamed' for IV changes. Look at it this way. If
option buyers and that means calls and/or puts far outnumber sellers, then
sellers must demand a higher price even when the stock has not moved. If
buying continues, prices move higher again. This is normal market behavior, no
matter what product is being traded

Market maker positions: When they sell options to the buyers, their
primary job is to reduce risk. They must buy other options, preferably on the
same underlying
It's true that most of today's traders use computers to generate orders to buy/sell
options in different underlying assets. However, after selling to public or
institutional buyers, the market makers preferable next move is to buy, rather
than sell more options. So they raise their bids and offers. To do that, they raise
the estimated future volatility estimate built into their trading algorithm. This is not
a conspiracy. Each trader independently raises or lowers bid according to his/her
need to own/sell vega, gamma, theta delta, etc.
Those algorithms tell their quote-generating computers to raise or lower the
trader's bid/ask quote
It's true that different market makers make different quotes, but when there is
more demand for the options, then prices move higher

Fear/complacency. When 'people' [individual investors, market makers,

speculators, hedge funds etc.] are afraid that the market may do something
drastic, or when they fear that their portfolios are not well-hedged against
potential losses, they buy options as insurance. It doesn't matter whether they

buy puts or calls [Remember that puts are calls and calls are puts], the purchase
of any option can drive prices higher when there are enough buyers.
We have all seen SPX volatility (as measured by VIX) decline from over 80 to 15
over the past two years. And even traders who have not been in the market that
long have seen IV decline over recent times. They've seen it, but do they
understand why this has happened? Today's questioner apparently has not
given it a moment's thought. It happened because the markets have been dead.
Extreme low volatility begets option sellers. But, at some point, sellers become
buyers.
I don't know if the decline in IV is ended, or if the current increase is just a bump
in the road. I do know that someone traded an iron condor without any
understanding of what could happen to his position other he would collect time
decay.

For How long?

Another impossible question. Until there are enough option sellers to satisfy the
buyers without prices moving higher.
I truly hope this gives you a more clear understanding of the markets. They are
very complex and not easily understood. I guarantee this: Neither you nor I will
ever understand them well enough to be able to just print money. Trading is
difficult work and it takes training and education and skill to succeed. The sad
fact is that some people have no chance.
If you take the time to understand how each trade makes or loses money, what
must occur for that profit or loss to be realized, and if you can discover how to
estimate the probability that such events will occur, then you are ready to trade
options.
If you open positions based on theta alone, you will not be one of the success
stories. You have work to do. Good luck and good trading.

Theoretical Pricing Models: Binomial Option Pricing and the

Black-Scholes Formula
Although several factors have been considered in what
determines an option's worth, it is intuitively obvious
that what actually determines the worth of an

option is the probability that the option will be in

the money by expiration, and by how much.
Everything else can be subsumed under these 2
variables. If a given variable increases the option
premium, it is because it increases 1 or both factors.
Thus, the reason why a greater amount of time until
expiration or a greater volatility increases premiums is
because there is a greater chance that the option will
be in the money by expiration, and by a larger amount;
likewise, premiums are low for an option way out of the
money, because there is little chance that the
underlying asset will reach the strike price by
expiration.
While prices and time intervals are easy enough to
measure, what cannot be known with certainty is the
volatility of the underlying asset, and therefore, the
probability that an option will be in the money or by
how much, before expiration. Historical volatility is
not necessarily a good indicator of future volatility,
although it does provide some measure of volatility.
Various pricing models have been developed in an
attempt to more accurately gauge the true worth of
options, or to price them better initially, when they are
first created.
The binomial option pricing model starts by
evaluating what a call premium should be if the
underlying asset can only be 1 of 2 prices by
expiration. A variable that can only be 1 of 2 values is
known as a binomial random variable. By

subdividing the time into smaller time intervals with 2

possible prices that are closer together, a more
accurate option premium can be calculated. As the
number of time periods increases, the distribution of
possible stock prices approaches a normal
distributionthe familiar bell curve.

The
probability of a stock price is proportionate to the height of the curve.

The Black-Scholes formula is the most widely used

formula to calculate option premiums. Much easier to
use than the binomial option pricing model, it,
nonetheless, is dependent on assessing the volatility of
the underlying asset, which is denoted by the standard
deviation, , of the underlying asset prices about the
current price.
Although the Black-Scholes formula calculates the premium for a
call, the put premium can be calculated by using the put-call parity
formula.
Note from this formula, that the standard deviation, ,
which is a measure of volatility, can be calculated if the
other variables are known. This is called the implied
volatility, because it is implied by the other variables.
Some traders compare the implied volatility with the
observed volatility to judge whether an option is fairly
priced.

Why Volatility Increases Time Value and Option Premiums

Volatility is the unknown change in price of the underlying security over time,
and is what gives options any value at all. For instance, consider a hypothetical
stock with a price that never changes. An option based on such a stock would
never have any time value, because the underlying is always the same price,
therefore, no one would want the optionneither put nor callif it was out of
the money. On the other hand, no one would sell an option based on this stock
that was in the money, because it would certainly be exercised. Now consider
another hypothetical scenario where the stock changed price according to some
formula, so that anyone could calculate the stock price with certainty at any
time. Again, there would be no time value to any option based on this stock,
because its price at any time can be known by anyone. For instance, if this
stock were $50 today, and it was known for certain that, before a specific
expiration date, it would be $60, then no one would write a call with a $50
strike, unless they were getting $10 per share (although maybe they would
charge a little less to get the money sooner) and no one would buy this call
unless it were discounted enough to at least equal prevailing interest rates.
Thus, it is the unknown fluctuation in the underlying prices that gives options
value.

Stock

Prices

SSS

40

45

50

55

VVV

30

40

50

60

Now consider 2 hypothetical stocks, currently at $50 per share. Stock SSS is
relatively stable, and has ranged between $40 and $60 per share over the past
year, whereas stock VVV is more volatile, and has ranged from $30 to $70.
Further, assume that the chance is 1/5 that either stock will be at some specific
price within its historical range, listed in the table, at expiration. Obviously, a
call for VVV with a strike of $50 is going to command a higher premium than
the same call for stock SSS for the same expiration date, because there is a
20% chance that the VVV call premium will be worth $20 per share, and a 40%
chance that it will be worth at least $10 per share, the most that the call for
SSS will be worth. It is true that there is a chance that VVV will be at $30 per
share, and that SSS will be no less than $40 per share, but this doesn't matter,
because if the stock price is less than or equal to the strike price, then the
options will expire worthless, and the chance that they will expire worthless is
50% for both stocks. Thus, if the VVV call has a chance of paying $20 per
share, but the most that the SSS call will pay is $10 per share, and the chance
that they will expire worthless is the same, then it makes sense that the VVV
call is going command a higher premium, because it has a greater potential
payoff.

Volatility and Implied Volatility

Volatility, as applied to options, is a statistical
measurement of the rate of price changes in the
underlying asset: the greater the changes in a given
time period, the higher the volatility. The volatility of
an asset will influence the prices of options based on
that asset, with higher volatility leading to higher
option premiums. Option premiums depend, in part, on
volatility because an option based on a volatile asset is
more likely to go into the money before expiration. On
the other hand, a low volatile asset will tend to remain
within tight limits in its price variation, which means
that an option based on that asset will only have a
significant probability of going into the money if the
underlying price is already close to the strike price.
Thus, volatility is a measure of the uncertainty in the
expected future price of an asset.
An option premium consists of time value, and it may
also consist of intrinsic value if it is in the money.

Volatility only affects the time value of the option

premium. How much volatility will affect option prices
will depend on how much time there is left until
expiration: the shorter the time, the less influence
volatility will have on the option premium, since there
is less time for the price of the underlying to change
significantly before expiration.
Higher volatility increases the delta for out-of-themoney options while decreasing delta for in-the-money
options; lower volatility has the opposite effect. This
relationship holds because volatility has an effect on
the probability that the option will finish in the money
by expiration: higher volatility will increase the
probability that an out-of-the-money option will go into
the money by expiration, whereas an in-the-money
option could easily go out-of-the-money by expiration.
In either case, higher volatility increases the time value
of the option so that intrinsic value, if any, is a smaller
component of the option premium.

Implied Volatility is Not Volatility It Measures the Demand Over

Supply for a Particular Option
Because volatility obviously has an influence on option
prices, the Black-Scholes model of option
pricing includes volatility as a component plus the
following factors:

strike price in relation to the underlying asset price;

the amount of time remaining until expiration;

interest rates, where higher interest rates increase the call

premium but lower the put premium;

dividends, where a higher dividend paid by the underlying

asset lowers a call premium but increases the put
premium.

The Black-Scholes formula calculates only a theoretical

price for a call premium; the theoretical price for a put
premium can be calculated through the put-call parity
relationship. However, the actual value the market
price of an option premium will be determined by
the instantaneous supply and demand for the option.
When the market is active, the following factors are
known:

the actual option premium

strike price

time until expiration

interest rates

any dividend
Therefore, volatility can be calculated with the BlackScholes equation or from another option-pricing model
by plugging in the known factors into the equation and
solving for the volatility that would be required to yield
the market price of the call premium. This is what is
known as implied volatility. Implied volatility does
not have to be calculated by the trader, since most
option trading platforms provide it for each option
listed.

Implied volatility makes no predictions about future

price swings of the underlying stock, since the
relationship is tenuous at best. Implied volatility can
change very quickly, even without any change in the
volatility of the underlying asset. Although implied
volatility is measured the same as volatility, as a
standard deviation percentage, it does not actually
reflect the volatility either of the underlying asset or
even of the option itself. It is simply the demand over
supply for that particular option, and nothing more.

Generally, in a rising market, calls will generally have a

higher implied volatility while puts will have a lower
implied volatility; in a declining market, puts will have
a higher implied volatility over calls. This reflects the
increased demand for calls in a rising market and a
rising demand for puts in a declining market.
A rise in the implied volatility of a call will decrease the
delta for an in-the-money option, because it has a
greater chance of going out-of-the-money, whereas for
an out-of-the-money option, a higher implied volatility
will increase the delta, since it will have a greater
probability of finishing in the money.
Implied volatility is not present volatility nor future
volatility. It is simply the volatility calculated from the
market price of the option premium. There is an
indirect connection between historical volatility and
implied volatility, in that historical volatility will have a
large effect on the market price of the option premium,
but the connection is only indirect; implied volatility is
directly affected by the market price of the option
premium, which, in turn, is influenced by historical
volatility. Implied volatility is the volatility that is
implied by the current market price of the option
premium. That implied volatility does not represent the
actual volatility of the underlying asset can be seen
more clearly by considering the following scenario: a
trader wants to either buy or sell a large number of
options on a particular underlying asset. A trader may
want to sell because he needs the money; perhaps, it
is a pension fund that needs to make payments on its
pension obligations. Now, a large order will have a
direct influence on the pricing of the option, but it
would have no effect on the price of the underlying. It
is clear to see that the price change in the option
premium is not effected by any changes in the volatility
of the underlying asset, because the buy or sell orders
are for the option itself, not for the underlying asset. As
a further illustration, the implied volatility for puts and

calls and for option contracts with different strike prices

or expiration dates that are all based on the same
underlying asset will have different implied volatilities,
because the different options will each have a different
supply-demand equilibrium. This is what causes the
volatility skew and volatility smile. Thus, implied
volatility is not a direct measure of the volatility of the
underlying asset.
Implied volatility varies with the change in the supplydemand equilibrium, which is why it measures the
supply and demand for a particular option rather than
the volatility of the underlying asset. For instance, if a
stock is expected to increase in price, then the demand
for calls will be greater than the demand for puts, so
the calls will have a higher implied volatility, even
though both the calls and the puts are based on the
same underlying asset. Likewise, puts on indexes, such
as the S&P 500, may have a higher implied volatility,
since there is a greater demand by fund managers who
wish to protect their position in the underlying stocks.
At the same time, the same fund managers generally
sell calls on the indexes to finance the purchase of puts
on the same index; such a spread is referred to as
acollar. This lowers the implied volatility on the calls
while increasing the implied volatility for the puts.
Because implied volatility is a measure of the
instantaneous demand-supply equilibrium, it can
indicate that an option is either over- or under-priced
relative to the other factors that determine the option
premium, but only if implied volatility is not higher
because of major news or because of an impending
event, such as FDA approval for a drug or the results of
an important court case. Likewise, implied volatility
may be low because the option is unlikely to go into
the money by expiration. If implied volatility is high
because of an impending event, then it will decline
after the event, since the uncertainty of the event is

removed; this rapid deflation of implied volatility is

sometimes referred to as a volatility crush.
However, implied volatility that is merely due to the
normal statistical fluctuation of supply and demand for
a particular option may be used to increase profits or
decrease losses, especially for an option spread. If an
option has high implied volatility, then it may contract
later on, reducing the time value of the option premium
in relation to the other price determinants; likewise,
low implied volatility may have resulted from a
temporary decline in demand or a temporary increase
in supply that may revert to the average later. So high
implied volatility will tend to decline, while low implied
volatility will tend to increase over the lifetime of the
option. Thus, implied volatility may be an important
consideration when setting up option spreads, where
maximum profits and losses are determined by how
much was paid for long options and how much was
received for short options. When selecting long options
for a spread, some consideration should be given to
selecting strike prices that have lower implied
volatilities, while strike prices for short options should
have higher implied volatilities. This lowers the debit
when paying for long spreads while increasing the
credit received for selling short spreads.
Although the implied volatility varies widely among
different assets, including different stocks, different
indexes, different futures contracts, and so on, the
volatility of an index will usually be less than the
volatility of individual assets, since an index is a
measure of the price changes of all of the individual
components of the index, where assets with greater
volatility will be offset by other assets with lower
volatility.

Diagram showing the difference in the expected price distribution about the mean for a
volatile and a non-volatile stock.

Implied volatility, like volatility, is calculated as

an annual standard deviation, expressed as a
percentage, that can be used to compare implied
volatility of different options that are not only based on
the same asset, but also on different assets, including
stocks, indexes, or futures. Moreover, the other factors
of the option-pricing model, such as interest and
dividends, are also usually expressed as an annual
percentage. Most trading platforms calculate the
implied volatility for the different options.
The standard deviation is a statistical measure of
the variability and, therefore, of volatility of an
underlying asset and can be useful in predicting the
probability that the asset will be within a particular
price range. In a normal distribution, which
characterizes the price variation of most assets, 68.3%
of price changes of the underlying asset over a 1-year
period will be within 1 standard deviation of the mean,
95.4% will be within 2 standard deviations, and 99.7%
will be within 3 standard deviations. Volatility
determines how wide the standard deviation is. If there
is little variability, then the normal distribution will be
much narrower, whereas for a highly variable asset, the
normal distribution would be much flatter, where 1
standard deviation would encompass a wider variability
in pricing over a unit of time. So if a stock has a mean
price of $100, and has a volatility percentage of 15%,

then during the course of the year, the price of the

stock will stay within $15 for 68.3% of the time.

Vega and Other Measures of Volatility

Vega measures a change in the theoretical option price
caused by a 1-point change in implied volatility. For
instance, an option with a vega of .01 will increase by
$10 per contract (which consists of 100 shares) for
each point increase in volatility and will lose $10 per
contract for each 1% decline in volatility. For the short
position, vega would have the exact opposite effect,
where a 1-point increase in volatility would decrease
the value of the short option by $10.
Most options have both intrinsic value and time value.
Intrinsic value is a measure of how much the option is
in the money; the time value is equal to the option
premium minus the intrinsic value. Thus, time value
depends on the probability that the option will go into
the money or stay into the money by expiration.
Volatility only affects the time value of an option.
Therefore, vega, as a measure of volatility, is greatest
when the time value of the option is greatest and least
when it is least. Because time value is greatest when
the option is at the money, that is also when volatility
will have the greatest effect on the option price. And
just as time value diminishes as an option moves
further out of the money or into the money, so goes
vega.
There are general measures of volatility that represent
volatility of entire markets. The Chicago Board Option
Exchange (CBOE) Volatility Index (VIX) measures the
implied volatility on the options based on the S&P 500
index. This is not the same as implied volatility of the
underlying stocks that compose the S&P 500 index, but
as a measure of the implied volatility of the options on
those stocks. VIX is also known as a fear index,
because it presumably measures the amount of fear in

the market; in actuality, it probably causes fear rather

than reflecting fear, because higher fluctuations in the
supply and demand for the options creates more
uncertainty. Other measures of general volatility
include the NASDAQ 100 Volatility Index (VXN), which
measures the volatility of the NASDAQ 100, which
includes many high-tech companies. The Russell 2000
Volatility Index (RVX) measures the volatility of the
index composed of the 2000 stocks in the Russell 2000
Index.

Volatility Skew
Volatility skew is a result of different implied
volatilities for different strike prices and for whether
the option is a call or put. Volatility skew further
illustrates that implied volatility depends only on the
option premium, not on the volatility of the underlying
asset, since that does not change with either different
strike prices or option type.
How the volatility skew changes with different strike
prices depends on the type of skew, which is influenced
by the supply and demand for the different options.
A forward skew is exhibited by higher implied
volatilities for higher strike prices. A reverse skew is
one with lower implied volatilities for higher strike
prices. A smiling skew is exhibited by an implied
volatility distribution that increases for strike prices
that are either lower or higher than the price of the
underlying. A flat skew means that there is no skew:
implied volatility is the same for all strike prices. The
options of most underlying assets exhibit a reverse
skew, reflecting the fact that slightly out-of-the-money
options have a greater demand than those that are in
the money. Furthermore, out-of-the-money options
have a higher time value, so volatility will have a
greater effect for options that only have time value.
Thus, a call and a put at the same strike price will have

different implied volatilities, since the strike price will

likely differ from the price of the underlying,
demonstrating yet again that implied volatility is not
the result of the volatility of the underlying asset.
Options with the same strike prices but with different
expiration months also exhibit a skew, with the near
months generally showing a higher implied volatility
than the far months, reflecting a greater demand for
near-term options over those with later expirations.

Implied Volatility - IV

What is 'Implied Volatility - IV'

Implied volatility is the estimated volatility of a security's price. In general, implied
volatility increases when the market is bearish, when investors believe that the
asset's price will decline over time, and decreases when the market is bullish,
when investors believe that the price will rise over time. This is due to the
common belief that bearish markets are riskier than bullish markets. Implied
volatility is a way of estimating the future fluctuations of a security's worth based
on certain predictive factors.

BREAKING DOWN 'Implied Volatility - IV'

Implied volatility is sometimes referred to as "vol." Volatility is commonly denoted
by the symbol (sigma).

Implied Volatility and Options

Implied volatility is one of the deciding factors in the pricing of options. Options,
which give the buyer the opportunity to buy or sell an asset at a specific price
during a pre-determined period of time, have higher premiums with high levels of
implied volatility, and vice versa. Implied volatility approximates the future value of
an option, and the option's current value takes this into consideration. Implied
volatility is an important thing for investors to pay attention to; if the price of the
option rises, but the buyer owns a call price on the original, lower price, or strike
price, that means he or she can pay the lower price and immediately turn the
asset around and sell it at the higher price.
It is important to remember that implied volatility is all probability. It is only an
estimate of future prices, rather than an indication of them. Even though investors
take implied volatility into account when making investment decisions, and this
dependence inevitably has some impact on the prices themselves, there is no
guarantee that an option's price will follow the predicted pattern. However, when
considering an investment, it does help to consider the actions other investors are
taking in relation to the option, and implied volatility is directly correlated with
market opinion, which does in turn affect option pricing.

Another important thing to note is that implied volatility does not predict the
direction in which the price change will go. For example, high volatility means a
large price swing, but the price could swing very high or very low or both. Low
volatility means that the price likely won't make broad, unpredictable changes.
Implied volatility is the opposite of historical volatility, also known as realized
volatility or statistical volatility, which measures past market changes and their
actual results. It is also helpful to consider historical volatility when dealing with
an option, as this can sometimes be a predictive factor in the option's future price
changes.
Implied volatility also affects pricing of non-option financial instruments, such as
an interest rate cap, which limits the amount by which an interest rate can be
raised.

Option Pricing Models

Implied volatility can be determined by using an option pricing model. It is the
only factor in the model that isn't directly observable in the market; rather, the
option pricing model uses the other factors to determine implied volatility and call
premium. The Black-Scholes Model, the most widely used and well-known
options pricing model, factors in current stock price, options strike price, time until
expiration (denoted as a percent of a year), and risk-free interest rates. The
Black-Scholes Model is quick in calculating any number of option prices.
However, it cannot accurately calculate American options, since it only considers
the price at an option's expiration date.
The Binomial Model, on the other hand, uses a tree diagram, with volatility
factored in at each level, to show all possible paths an option's price can take,
then works backwards to determine one price. The benefit of this model is that
you can revisit it at any point for the possibility of early exercise, which means
that an option can be bought or sold at its strike price before its expiration. Early
exercise occurs only in American options. However, the calculations involved in
this model take a long time to determine, so this model isn't best in rush
situations.

What Factors Affect Implied Volatility?

Just like the market as a whole, implied volatility is subject to capricious changes.
Supply and demand is a major determining factor for implied volatility. When a
security is in high demand, the price tends to rise, and so does implied volatility,
which leads to a higher option premium, due to the risky nature of the option. The
opposite is also true; when there is plenty of supply but not enough market
demand, the implied volatility falls, and the option price becomes cheaper.
Another influencing factor is time value of the option, or the amount of time until
the option expires, which results in a premium. A short-dated option often results
in a low implied volatility, whereas a long-dated option tends to result in a high
implied volatility, since there is more time priced into the option and time is more
of a variable.
For an investor's guide to implied volatility and a full discussion on options,
read Implied Volatility: Buy Low and Sell High, which gives a detailed description
of the pricing of options based on the implied volatility.
In addition to known factors such as market price, interest rate, expiration date,
and strike price, implied volatility is used in calculating an option's premium. IV
can be derived from a model such as the Black Scholes Model.