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 options value consists of several components The strike price, expiration date, the current stock price, dividends paid by the stock (if any), the

Implied Volatility

volatility of the stock and interest rates. Instead of substituting a volatility parameter into an option model (e.g. BlackScholes) to determine an option's fair value, the calculation can be turned round, 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 options 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.

Implied Volatility

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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 options strike is from the market price of the underlying instrument, the higher the options 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
Sr. Vice President& Head Derivatives Tel +91-22-67897833 Email: Karun.mutha@hsbcinv.com

same time has identified a price skew where the implied volatility of the strike price they are selling is significantly higher than the implied volatility they are buying. The option strategist would implement a bull call spread as the best 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. The other type of skew is the time skew and it is identified by different levels of implied volatility on stock options with the same or sometimes different strike 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.

Tina Khetan
Analyst - Derivatives Tel +91-22-67897828 Email: Tina.khetan@hsbcinv.com

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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

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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 stocks 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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