Implied Volatility

Discussion in 'Options' started by isoroi, Dec 14, 2006.

  1. isoroi


    Can someone explain to me how to interpret IV?

    I tried to do research on the web to get a better grasp of this concept, but it always seems to confuse me.

    The higher the iv, the higher the option premiums will be in relationship to their expiration. Is this correct?

    I also read that there is numerous methods of calculating the IV, and that there is no standardized method of calculating it.

    I guess what annoys the piss out of me is that I can't figure out why I even should care about the IV. Shouldn't I be able to see the bloated option premium in relation to the stock price and derrive the same information I would by looking at the IV?
  2. MTE


    Well, how would you know that the option premium is bloated? What are you gonna compare it to?

    IV is calculated by taking the market option premium and then reversing an option pricing model to get the volatility. In option pricing the only unknown variable is the volatility, all others are easily observable. Higher IV means more expensive options, lower IV cheaper options, but you cannot use it in absolute terms, it's used on a relative basis.

    Implied volatility tells you what the market's expectation is for future stock volatility (i.e. possible range of prices).
  3. IV is a number like stock price is a number, it's relative. There are some differences. Some believe that IV is mean reverting. The conventional wisdom says buy low, sell high. In other words, if IV is high (relatively speaking), you should be selling options, if IV is low, you should be buying. Why? Because if IV is mean reverting, you should be able to profit from the mean reversion. You should be "aware" of IV because if you're buying calls to go long on the underlying when IV is through the roof, the price of the underlying could move favorably and you could still lose while the volatility bleeds. You can clearly see why should care by using any old options calculator. Take the price of a call today with the current IV and then take that same price and lower the IV input 10-20% and see what the price of the call is now.

    Of course, you can also argue that high volatility could go higher or that low volatility could go lower (just like a stock price).

    There are folks around here that know much more about this than I do. You could probably search the archives and get a lot more help, but I hope this helped a little.

  4. isoroi


    Lets look at this stock for example:

    CVC Cablevision Systems Corporation
    Stock was at: $28.41

    Looking at the $30.00 strike options (CVCLF) which were selling for $1.95.

    Assuming I were to do a buy-write, my return would be around 6.86%.

    With only 2 days before option expiration, wouldn't that be classified as a bloated premium? Based upon that high of a premium, I'd expect news such as an earnings announcement before expiration.

    If my above analysis is correct, what does the IV tell me that is different? Or am I completely off base here?
  5. isoroi


    That analysis is helpful. I'm more interested in buy-write scenarios. So, I would need to know specifically how IV benefits in those particular situations.
  6. MTE


    I don't see CVC Dec 30 call trading at 1.95, it's 0 bid 0.05 ask. As myself and OP mentioned you need to look at IV from a relative perspective, that is relative to historical (aka statistical volatility) and/or past implied volatility levels.
  7. MTE


    Please don't be offended, but may I suggest a book on options, such as "Option Volatility and Pricing" by Natenberg. It seems that you don't really understand the concept of volatility in options. Hence, you don't see the value in it.
  8. isoroi


    This was using yesterday's closing data. It wasn't supposed to be a realtime example, just an example.
  9. isoroi


    I'm not offended. I've started reading a couple books, but to be quite honest, my eyes start to glaze when it starts talking about the option pricing and volatility.

    I was hoping for a specific, 101 type answer on how IV affects me as an option writer.
  10. MTE


    No way it was yesterday's close example. That call has been trading below 0.35 since October.

    In any case, here's an example for you.

    Say you got two stocks, both at the same price. The equivalent calls are trading at 1.20 and at 2.65.

    Which one is more bloated? The first one or the second one?

    And what if I told you that the second stock is twice as volatile as the first! Would your answer be still the same?

    Finally, what if I told that the first stock's current IV is twice the IV it has exhibited in the past?
    #10     Dec 14, 2006