OAP 135: You Don’t Need A Degree In Financial Engineering To Understand How Implied Volatility Works

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Today we'll condense potentially an entire semester of financial engineering into a single podcast episode. The goal being to help completely understand how implied volatility works, why we need it, where it comes from, and how we can profit from it as option sellers. This show is a little longer than normal but I think the time spent walking through the foundational elements of implied volatility and it's impact on option pricing are critical for anyone interested in generating long-term income as an option seller. I encourage you also to listen to this episode multiple times if needed. Enjoy!

Key Points from Today's Show:

  • Implied Volatility can be a complicated topic on the surface, but once you peel back some of the layers is it actually very easy to understand. 
  • The core of what we do as options traders is to use IV to our advantage, selling rich IV compared to historical standards and trying to profit from the mispricing that occurs.

Why Does Implied Volatility Exist?

  • Stocks are totally different than options.
  • They are understandable and valued on a forward-looking basis.
  • Do not have to factor into the price the expiration that the stock might go through.

With options, there are two things to consider:

1. A finite life — options contracts have a definitive date in which they expire and cease to exist. 

2. Strike prices — the idea that you can pinpoint the strike prices in which you trade contracts, which could be the same price as the stock or dramatically higher or lower than the stock price.

So how do you price in these additional factors? How do we determine a value for something that can die in the future but potentially has value now? How is the value determined for something that has a significantly higher or lower strike price than the stock price?

1. Time Value 

  • We give value to time.
  • The further out something is, the more time value it has. 
  • If it has a long life expectancy, there is potential that it has a better chance of moving into a profitable range. 

Example: If you are trading a stock that is at $100 and you trade an option contract that is 2 years out, there are 2 years for it to move into a profitable range. 

However, if you have an options contract that is 2 days out, after 2 days the options contract no longer exists. So those 2 days become critically important — only 2 days for things to go either right or wrong. 

2. Volatility

  • The understanding that you have to assign some sort of expected or future movement in the stock to the option contracts. 
  • Determine how volatile the stock is going to be moving forward into the future. 
  • How far do you expect the stock to move in the future? 
  • You have to factor in some sort of expectation of volatility, which dictates the value of strike prices. 

Example: If the stock is trading at $100 and you expect the stock to move nowhere for the next year, zero implied volatility. Therefore, if you know for a fact that the stock will never be lower or higher than $100 all year, almost no value would be associated with any options contracts that have a strike price higher or lower than $100. 

If there is no expected volatility, then there is no value that can be derived from option contracts that are at different strike prices beyond $100. 

How do you determine how far a stock may or may not move in the future?

  • This determination then leads to the value of the underlying contracts. 

Example: If the stock is trading at $100 and you expect huge movements up or down by 100% in the next year. Now option contracts become valuable. The trades that end up being made depends on which way you think the stock will move. In either case, whether the stock goes up or down, a value is assigned to these option contracts because of the potential to profit. 

What is Implied Volatility at its core?

  • Implied Volatility represents, as a percentage, the annualized expected or one standard deviation range for a stock. 
  • IV captures the one standard deviation of a log-normal distribution, which is 68% of the probable outcomes.

Example: If you have an IV of 25% and a stock is trading at $200, then you are expected that the stock moves in a range, up or down, of $50 into the future (25% of $200 is $50) between now and the end of the year. The IV number of 25% captures a 68% probable range.

IV does not capture all of the possible ranges — it can never capture 100% of the possible range.

A 2 standard deviation range would capture about 95% of the expected move. So if you double the IV to 50%, that is a move up or down of $100. So there is a 68% chance that the stock moves up or down by $50, but a 95% chance that the stock moves up or down by $100. 

How do we get this IV number?

  • When you look at how options are priced, most pricing models use the Black Scholes Model.
  • The Black Scholes Model uses a variety of inputs to then determine the value of an options contracts.
  • Inputs include things like:
    - Where is the option strike price compared to where the stock is?
    - Does it have intrinsic value, or not?
    - How far are you from expiration?
    - Are interest rates low or high?
  • The Black Scholes Model also includes, as a function of the options price, implied volatility.
  • As a general rule, when implied volatility is higher, option prices are higher across the board (all other things being equal).
  • When you expect the stock to have huge movements, option prices on both sides increase.
  • Generally, when implied volatility is low, that means that option prices are generally low (all other things being equal).
  • Because IV is forward-looking, you have to use it as an input for the Black Scholes Model.

So how do you determine IV when just getting started?

  • We determine IV based on at the money and near at the money pricing of options contracts. 
  • This is a backward way of discerning what IV ends up being.
  • Market makers and computer systems look at what people are willing to pay for at the money and near at the money contracts.
  • Based on their activity and their willingness to buy option contracts or not, that derives how far people expect the market to move. 
  • IV is user-generated
  • IV is discerned through buying behaviors of market participants.

Example: the stock is trading at $100. Someone who is buying the $100 strike call option is willing to pay $5 for that option contract. Through their buying actions, they have shown that they expect the stock to at least move 5% moving forward in the future. If you are only willing to pay $4, then you show that you expect a 4% IV in that option over the next year. Again, through your buying behavior, you derive the expected movement of the stock in the future. 

If you are willing to pay $15 for the option contract, you know that you will not be profitable unless the stock is worth more than $115 in the future. So, therefore, you are expecting a 15% move in the stock. Again, your actions derive what people expect — the supply and demand concept. 

  • IV Calculations only use at or near at the money contracts, because those are the most liquid, the most traded, so it gives the system as much information as possible then to derive what IV is. 
  • Once IV is determined based on how actively people are trading, it can then discern volatility and project volatility values for out of the money contracts. 
  • Out of the money, contracts are using pricing for volatility based on at the money contracts.
  • As buying behavior changes, implied volatility goes up and down, moving and shifting to the market at all times. 
  • If there is no expected movement from the stock in the future, then the value of options go down. 

How do we use IV to our advantage?

Example: If the stock is trading at $100 and you buy the $100 strike call option for $5, that does not tell you anything about whether or not the stock is going to move $5 in the future. That is just simply how much you are willing to pay — your best guess at predicting the future. 

As a long-term average, the implied volatility number that market participants have generated through their buying activities is over-stated by some margin every single month.

If you expect the stock to move $5 this month, you usually find that the stock only moves $3. If you expect the stock to move $15, you will find that that stock only moves $13. It is always over-stated long term. 

Why is IV always over-stated long term?

1. We are bad at pinpointing future movements of stocks.

2. When we expect things to move, we are either too optimistic or too pessimistic. 

3. Black Swan events are unpredictable by their nature.

  • In normal markets, we have time periods where people start to become better at predicting the future movement, or it starts to become a much more narrow edge. 
  • This generally happens during low implied volatility markets, which makes it a lot easier to predict stock movements. 
  • What inevitably happens is a Black Swan event comes along.
  • Black Swan events are an integral part of what we are doing as option sellers.
  • Without Black Swans, we would have no edge in option selling.

Example: Everything is running smoothly; we expect a 10% move and see a 10% move. Then a Black Swan event comes along and we either get a huge drop or a huge move up in the stock. In the next year, the stock rallies 50%, which is way more than expected. This sets the new foundation for where people expect the market to go.

When IV escalates like that in a Black Swan event and the stock goes up 50%, now people start expecting 30-40% moves or maybe 50% moves the next year. That's when they start over-paying for options contracts by a huge margin. When this happens, we see a huge differential between what the actual value is at the end of the year and what people pay. 

In these scenarios, it is better to be an option seller than an option buyer. 

On average, IV is always higher by some margin compared to historical.

This presents a huge edge as option sellers to derive our income from this theoretical "edge".

If everyone knows that IV is always higher than historical volatility, why can't we perfectly price everything?

  • Option contracts are perfectly priced at the time of execution. 
  • When you get into an option contract, the day that you buy or sell an option contract, it is perfectly priced based on all the parameters that the market has at that exact time, including the expectation of future movement. 
  • The market is perfectly efficient in pricing everything at the time of execution, based on the information it has.
    The inefficiency comes with patience, and the only time that the mispricing happens is after you get through the time period between order execution, order entry, and expiration. 
  • Once you wait through that time period, then the mispricing (the differential between implied and actual volatility) starts to materialize.
  • On order execution, an option buyer who's assuming a 25% move has got to see a 25% move in that stock. 
  • This does not mean that the pricing on order entry was inefficient — it was correctly priced based on what the market had at the time. 
  • Once you get to expiration, you find out that reality is different from expectation. 
  • The IV edge takes time to unfold and materialize.

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  • Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We'll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
  • Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You'll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
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Option Trader Q&A

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today's question comes from someone, who asks:

How do you adjust naked puts and calls that have moved against you?

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

PDF Guides & Checklists:

  • The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
  • Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
  • Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
  • Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
  • When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we'll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.
  • 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.

Real-Money, LIVE Trading:

  • EWZ Iron Butterfly (Closing Trade): After nearly pinning the stock at our short strikes, and thanks to the volatility drop, we netted a $600 profit on this iron butterfly trade.
  • VXX Short Call (Closing Trade): One of the most consistent and profitable options trades we can make is shorting pure volatility with VXX and today we closed this naked short call in VXX after a couple days for a $420 profit.
  • DIA Iron Condor (Adjusting Trade): This neutral iron condor in DIA is need of a quick adjustment early this week as the market continues to rally. In this video, we'll discuss why I'm adding an additional put credit spread while also choosing NOT to close out of our current put credit spread due to pricing reasons.
  • COP Short Put (Closing Trade): These single short puts in COP acted as a great hedge for our other bearish bets in oil this month and helped smooth out our returns after we closed them for a nice big profit.
  • TSLA Put Debit Spread (Closing Trade): Although many people thought we were crazy for getting bearish in TSLA this pre-earnings put debit spread trade made us $200 today. After the huge run up from $140 to $260 and getting some technical sell signals, we were pretty sure this stock would pull back.
  • MON Iron Condor (Closing Trade): Following a huge drop in implied volatility we worked hard to close this MON iron condor trade adjusting the order multiple times to fill before the end of the day.
  • IBB Call Debit Spread (Opening Trade): We'll show you how I started searching for a new bullish trade and eventually found a low volatility trade in IBB looking for a move higher to hedge our portfolio.
  • TLT Iron Butterfly (Closing Trade): Following the Brexit vote TLT and bonds traded in a nearly $8 range really quickly - even still the drop in implied volatility helped generate a $330 profit for us.
  • XBI Call Debit Spread (Closing Trade): Got lucky picking the exact bottom for our entry in this call debit spread for the XBI biotech ETF which ultimately was closed for a profit of $165 today on the rally higher.
  • COH Iron Butterfly (Earnings Trade): Shortly after the market open we close out of our COH earnings trade for about a $160 profit, leaving just 1 leg on to expire worthless.
  • EWW Debit Spread (Closing Trade): Using some of the technical analysis signals we discovered in our backtesting research, we were able to make a quick $130 profit on this bearish EWW debit spread trade.
  • IBM Iron Condor (Earnings Trade): Shortly after the market opened you'll follow along with me as we watch volatility drop and liquidity come into the market before closing out the position for $250 profit.
  • SLV Short Straddle (Opening Trade): Using our watch list software we decided to continue to add to our existing SLV short straddle position with a new set of strike prices reflective of the move lower in the ETF recently.

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and two daughters.