Hi guys I'm trying to wrap my head around IV. Still a newbie in the options world. Hope someone can explain this as easy as possible in plain english For example.. lets say xyz is trading at $100 today on Sept 18. The call option for $102 Oct 18 is selling for $3 and the implied volatility is 60%. What is the 60% IV telling me? thanks in advance!
The 60% is telling you what the market says the volatility is given the current price for the option. However, you can't solve for IV directly from price using the Black-Scholes etc. models. You have to use mathematical methods such as Newton-Raphson or Bisections to solve for IV. IV is driven by supply/demand for the option itself, and thus is typically different than historical volatility of the underlying. Remember, you don't need to be a volatility guru, just a volatility Forest Gump. That is, to realize when IV is relatively high or relatively low.
There are about 255 days the exchange is open. The Square root of that is about 16. A 16 vol represents an expectation of about a 1% move on average each day. A 60 VOl implies 60/16=3.75 or about a 3.75% move per day. If you buy that vol, any day that stock moves more, you are better off. Less than that worst off, in general. If I believe that stock will only move 2.5% on average, moving forward, I would want to sell any Vol materially over 40. In your example if you were to buy calls and short stock, delta neutral, you would have the expectation of that stock moving more than 3.75 per day. Does that help? 1245
One slight correction. A 16 vol represents an expectation of a move of about a 1% standard deviation, not average. Assuming a normal distribution of daily moves, a 16 vol implies that mean (average) absolute move will be about 0.8%, median absolute move will be about 0.7%. Mean absolute move would be higher than 0.8 times sigma if the underlying distribution is leptokurtic.
It's an excuse to make BS valid and give it some scientific touch. For example, my model for a human height is: heigh = magic * pi Can't give you magic for all humans, you have to give me height, then I'll give you magic for that human. If height changes, I will adjust magic accordingly to keep my model mathematically correct.
If you understood black scholes you would be impressed with how elegant the formula is and how well it mimics real life.
Here is an intuitive explanation of implied volatility, without even mentioning Black/Sholes or stochastic calculus. You just need to understand the option payoff and how option price changes with the underlying. The thought process is actually pretty straight forward: (a) in order to lock in option value in a manner independent of the underlying asset direction, you need to neutralize the directional exposure of the option (that is, hedge delta). (b) if you neutralise the directional exposure on regular basis, you total P&L (at expiration) will depend on day-to-day changes in underlying and on the initial price of the option. (c) so, initial price of the option should be a function of some-kind of expectation of cumulative day-to-day changes. Understanding how that translates into BS or any other model is secondary, people have traded and delta-hedged options before BS (though BS did make the thought process much more intuitive).
What do you think comes first, option price or expected volatility of the stock? Let me ask you differently - if you have to buy or sell an option that does not have a listed market, how would you approach it?