Implied Volatility-Derivative Classroom Series V

September 24, 2009

Derivative Classroom -Series V

` Introduction

Implied Volatility can be defined as the volatility of an instrument as implied by

the prices of an option on that instrument, calculated using an options pricing
model. An option’s value consists of several components – The strike price,
expiration date, the current stock price, dividends paid by the stock (if any), the
volatility of the stock and interest rates.
Implied Volatility
Implied Volatility Instead of substituting a volatility parameter into an option model (e.g. Black-
Scholes) to determine an option's fair value, the calculation can be turned round,

ssss where the actual current option price is input and the volatility is output. Therefore
implied volatility is that level of volatility implied by the market given its current
trading option price.

This calculation can be very useful when comparing different options on the same
underlying & different strike prices. The Implied volatility can be regarded as a
measure of an option’s “expensiveness” in the market, and is used by traders
setting up combination strategies, where they have to identify relatively cheap and
expensive option contracts.

As there are many options on a stock, with different strike prices and expiration
dates, each option can, and typically will, have a different implied volatility. Even
within the same expiration, options with different strike prices will have different
implied volatilities.

Volatility Skew

Volatility Skew is U” shaped, the bottom of the “U” being the at-the-money strike.
From there, the skew rises on both sides. This formation is sometimes referred to
as the “smile” curve. The farther an option’s strike is from the market price of the
underlying instrument, the higher the option’s volatility.

Volatility skews are present when two or more options on the underlying have a
significant difference in implied volatility levels. The volatility skew gauges and
accounts for the limitation that exists in most option pricing models and is used to
give an edge in estimating an option's worth. There are two types of volatility
skews that exist in the marketplace, those being price and time.

Price skew occurs when the implied volatility differs across the strike prices of
options, on the same stock and the same expiration months. The options trader
has various strategies that are best utilized when a price skew has been identified.
Strategies include the bull call, bull put, bear call, bear put spreads as well as the
call ratio and put ratio back spreads. Just always remember when using either a
price skew or a time skew that the primary goal of the options strategist is to
be selling higher volatility and buying lower volatility.

For example, assume an investor is bullish on a particular underlying and at the

Karun Mutha same time has identified a price skew where the implied volatility of the strike
Sr. Vice President& Head Derivatives price they are selling is significantly higher than the implied volatility they are
Tel +91-22-67897833 buying. The option strategist would implement a bull call spread as the best
Email: Karun.mutha@hsbcinv.com
strategy. A bull call spread is a strategy in which a trader buys a lower strike call
and sells a higher strike call to create a trade with limited profit and limited risk.
Tina Khetan
Analyst - Derivatives
The other type of skew is the time skew and it is identified by different levels of
Tel +91-22-67897828 implied volatility on stock options with the same or sometimes different strike
Email: Tina.khetan@hsbcinv.com
prices, but different expiration months. Again, just as with the price skew, there
are particular strategies that work best and focus on selling higher volatility and
buying lower volatility.

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Implied Volatility-Derivative Classroom Series V
September 24, 2009

Derivative Classroom -Series V

Importance of Implied Volatility

Increase in IV can cause option pricing to go up and vise-a-versa. A 40% drop

in IV could be devastating to investor holding long options. Nothing could be
worse than to make a trade where the underlying stock went in your favor but
you lost to the trade as the volatility moved against you
Implied Volatility Sometimes option prices can reflect information about the fundamental value of
the underlying that is not immediately reflected in the price of the stock itself,
implying that the actual stock prices tend to move in the direction implied by the
ssss option prices”.

Implied Volatility V/s Historical Volatility

Implied volatility is a measure of expectations, if IV is higher than historical

volatility, traders expects the future volatility of the stock to be high relative to
the stock’s past level of volatility making the option expensive. But if implied
volatility is low compare to historical volatility, market players are expecting
lower level of volatility and option is said to be cheap.

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Inference

The best time to buy options is when IV is low compared to HV and we expect
the market will become more uncertain in the future so that IV escalates (and
option prices go up in value).

However relationship between the IV of the options we trade and the actual
volatility that the underlying stock displays it important. Of course, over time, IV
tends to move up and down with actual volatility, just as IV tends to move
toward HV. If a stock becomes more volatile over time, the market expects that
it will continue to be more volatile in the future, and IVs of the options tend to
go up.

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