Mentoring Session 8 Day 5

Implied Volatility
& Days Analysis
 Implied Volatility

In this section we shall focus upon

● What is Volatility?
● What is “Implied” in Implied Volatility?
● How can IV be used in Trading?

What is Volatility?
Volatility is one of the most important but least understood aspects of Options trading.
We will try to understand Volatility through something known as the “Normal Distribution
curve”.

Though it may sound a bit complex, just try to understand through this diagram.
Volatility refers to how far the price tends to go away from current price.

In the above diagram along the X axis are shown the price ranges and along Y axis is
the probability of occurrence. You can observe that for the Price of 34000 three points
have been marked in the graph 1,2 & 3. Out of them Point no 1 is highest along Y axis
thus has highest probability of occurrence, that means that price 34000 is likely to be
attained with highest probability when we have “Moderate-volatility”. On the basis of this
we will try to understand volatility.

Just consider the following hypothetical example.

Consider we are looking at BankNifty just before the Union Budget is to be announced.
Nobody knows what the real outcome would be. The budget may be good and the
Finance Minister may announce reduction in Corporate Tax rates or the budget may be
really disappointing wherein the same Finance Minister may announce a hefty increase
in Corporate Tax rates to finance the expenditure against Covid. There is a lot of
uncertainty with regard to outcome.
In case the budget is positive the Banknifty may move strongly from 33000 towards
34000. But in case the budget is negative, BankNifty may move down towards 32000 as
well. This situation is known as the “HIGH VOLATILE” environment.
Thus during times of high volatility prices tend to move farther away from the
mean or current price.
Just look at the “High Volatility Distribution” curve in the diagram. 33000 is the mean or
current position and the shape of the curve is relatively flat as compared to other other
curves. So what does this mean? It means that the probability of price to stay at 33000
itself is minimum when we have a high Volatility. Also the probabilities of extreme prices
like 35000 or 31000 is maximum when volatility is maximum.
Now observe the “Low Volatility Distribution” curve. As per this diagram the probability of
price to stay at 33000 itself is maximum in this kind of environment whereas chances of
price going to extreme levels like 35000 or 31000 are very low though not impossible.

So just summing it up, in High Volatility environment Prices tend to go very far away from
the current level whereas in Low Volatility environment Prices tend to stay around the
current level or mean prices.
What is “Implied” in Implied Volatility?
Implied Volatility is a concept that is unique to options in Derivative trading. The term
“Implied” is the most unique element.
Volatility is a mathematical concept and mathematical concepts are usually calculated
using some historical data. We also calculate volatility based upon the Historical price
changes of a security but such a Volatility is known as “Historical Volatility”. IV is
something that is derived out of Options Premium by reverse calculation. If you wish to
understand this concept then read the following text

I guess you remember what factors determine Options Premium. Here is a quick revision

We had mentioned earlier as well that Volatility is the most crucial factor in determining
the options premium.
Before knowing what Implied Volatility is, we will understand how it is calculated. We
know that options premiums are a reflection of demand and supply equilibrium. But
there are many mathematical models too that are used by sellers to determine the
correct option price. One of them is Black Scholes model. This computer model gives
optimum price of an option when we feed following inputs to the system
1. Spot price
 2. Interest Rate
3. Days to Expiry
4. Strike Price
5. Volatility
However what price we get as an output may or maynot be the same as the actual
options price.
Let us say the theoretical price of 33000 CE comes out to be Rs 126 but actual trading
price is Rs 150. So why is there a difference? Is our mathematical model flawed...NO. It
is because our input parameters are not correct. Out of all the input parameters it is
Volatility that is the problem. We do not know what the correct volatility is.
So we do a reverse calculation and calculate which Volatility level would give options
premium to be Rs 150. This reverse calculated Volatility is known as Implied Volatility.

So this is something that is Good to know but what is the significance of it? Well IV has
many advantages. If you compare IV with historical Volatility that can be calculated from
actual price variations we can come to know whether Volatility is high or low. Thus we
can plan to trade accordingly.

How can IV be used in Trading?

So in the previous section we learnt theoretical aspects of IV that is something I call

“Good to know” and which you may use sometimes to flaunt :) . But in the real world we
need to focus not upon what is IV but how do we use it to our advantage.
Before we proceed further I would like to draw a correlation between the Options
premium and the IV based on this above discussion

Higher is the IV higher is the premium.

Lower is the IV lower is the premium.
I guess that if you have understood the role of IV in determining the OPtions premium
this correlation can be easily understood.

Now we will dig a little deeper into IV to know what else it can offer Options buyers in
terms of information. For this we will see what IV generally represents.
So these are the two most important piece of information that IV provides us

RISK PERCEIVED BY SELLER

If there is too much Volatility around the corner such as the period before Budget Day or
RBI Monetary Policy or Fed Rate meeting then an option seller would like to sell the
option at a higher premium than usual premium. In such circumstances of uncertainty
Option Premiums will be high and so will be the IV.

This Risk factor will only be there around special occasions but during most of the times
it is Demand & Supply Imbalance that is reflected in IV levels across the Option chain.
This information will be the one of the most important pieces of information for options
buyers.

So let us discuss demand and supply first.

We must know two concepts to understand this phenomenon
● Higher Demand means higher Price
● Higher Supply leads to lower prices

That's it. You can think of it in terms of prices of Onions whose demand and supply often
gets distubed.
So how do we use this in Options trading?
We will use this aspect of IV to know where the buyers are concentrated by comparing
IV levels of Calls & Puts across the Option Chain.
This is a unique concept that you will not find in textbooks but is a result of observation
made by our Master Scalper, Mr. Sivakumar Jayachandran.

So do we need to compare all the strikes across the Option Chain?

NO. We should focus primarily on ATM and nearby strikes.

We will understand this by studying Nifty Options chain

We see here that the ATM strike is 15600.

Now 15600 CE’s LTP was 39.6 and 15600 PE’s LTP was 45. Certainly you see that PE
is more expensive than CE. So does that mean that there are more buyers on the PE
side?
The answer is NO. For determining where the Demand is higher we need to compare
IV’s and not Prices/premiums because premiums depend upon a lot of factors one of
which is IV.
Now IV of 15600 CE is 13.48 and that of 15600 PE is 12.62. So the buyers are inclined
towards buying CE’s rather than PE’s.
Now similarly compare the data for 3 strikes across the ATM it will give the same
analysis.
 So based on the difference in IV levels we can know where the buyers are concentrated.

But this is just one half of the story. We need to know how strong the sentiment of the
buyers is.
That is possible if we know the relative difference in IV levels. If IV levels differ by a big
amount then buyer sentiment is strong and if the difference is small then it is a weak
sentiment.
So what are those magical numbers?
This is again something that we know by virtue of 15 years of trading experience of Siva
Sir. So the different IV combinations that we are important to determine Market
sentiments are

10-10
10-15
20-20
20-30
40-40

We will discuss them one by one to understand their importance

1. IV Level 10-10
What we are actually referring to in the above statement is the scenario where the IV
levels on both the Call & Put are very low and of same magnitude.
So it may be 8-8 or 12-12, the concept is that the absolute IV number is low and the
difference of IV between Calls & Puts near ATM’s is almost zero.
● This scenario is very favourable for Option buyers.
● If IV is low then premiums are low.
● In such a situation any move in Bank Nifty/Nifty shall result in higher appreciation
of premiums.
We will understand this by comparing a high IV environment with a low IV environment
and what happens when Banknifty moves by 100 points. For simplicity we will assume Banknifty
spot to be at 30000 in both the environments
This is how IV impacts premium and change in premiums.
If IV is lower then any change in Bank Nifty will lead to greater change in Options premium
compared to situation when IV is higher.
Thus lower IV means greater opportunity for Option buyers and they should play aggressively in
such environments.

2. IV Level 10-15
This condition refers to a situation where buyers will try to dominate one side but without much
ammunition. Since Sellers will not abandon their fort option buyers are likely to suffer if they hold
their positions for too long.
In this case since sellers are active they will try their best to move the market against the buyers
and in this process the option premiums on side with higher iV will crash more faster.

Just observe this case. Here IV on Call side is around 80 and on Put side it is around 75 and
just note what happened to premiums on Call side when market fell down. It crashed much
faster whereas premiums on the Put side appreciated hardly anything.
Though we have mentioned levels as 10-15 but we want to stress more on the relative
difference here rather than absolute numbers.

In such an environment it is better to scalp and gain quick entry and exit.

3. IV Level 20-20
This situation is a writer's paradise. They will dominate both the sides and will not give any
chance to Option buyers. The sole objective of this pattern is to eat premium options. This
usually happens on Wednesday’s before the market expiry.
Just observe what happened to Banknifty options premium on both call and put sides when IV
levels were around 25 on both Call & Put.
On this day it is better to play Short Straddle as you will not get much moves on Banknifty/Nifty
as premium decay will be the order of the day.

4. IV Level 20-30

This situation is idle for options buyers. In this scenario Options buyers would just rush into the
system and take everything by storm. On this day you would see perfect quadrant formation in
OI spurts.
However, do note that this pattern occurs only for short duration thus it would be better to trail
your profits rather than waiting for the day’s end.

5. IV Level 40-40
This situation refers to the highly Volatile periods. During such periods because of high IV there
will be hardly any appreciation of premium even if the market moves in your direction. Consider
following example
In this example you see that IV on the Call side is around 47 and on the Put side it is around 61.
On this day the market fell quite significantly but notice how much the premiums of PE
increased despite the fall. On other hand notice the fall in Call premiums.
This is the magic of IV.

So now you realize why IV is an important factor in options trading.

So let’s summarize our understanding about IV.

● Higher IV Means higher premium and lower IV means lower Premium.
● IV signifies the demand and supply disequilibrium.
● In the option chain, if the IV of one side(assume CE) is higher than IV on the other
side(let us say PE) then it means that buyers are inclined towards the side with higher
IV(CE).
● We need to consider IV of the ATM and 3 nearby strikes in both directions for making a
conclusion.
● Buyer sentiment can be gauged by the relative difference between IV’s on both sides.
● Strong Buyer sentiment is signified by IV difference levels of 10 on both sides.
 ● Lower IV levels provide a good environment for buyers.
● In times of Higher IV levels small retail buyers should avoid the market.

Other learnings from IV

When IV is higher don't carry any overnight position as there will be more premium erosion so
gains would be less.
IV difference of more than 8 shall be favorable for option buyers in the direction where IV is
higher.

So today we learnt about the theoretical aspect of IV and OI spurts. In coming sessions we will
focus more on their practical aspect. So I would request you to brush up your concepts for the
upcoming session.
 Days Analysis
For today’s session we shall try to learn the importance of 2 consecutive candles of 50 K that
form an integral part of our 2 candles set up.
For sake of discussion we shall take into consideration the Open & High concept that we will
discuss in length in upcoming sessions.
Today we had a very strong Open & High setup forming on the put side

Though there are many points to take into consideration while analyzing Open and high but
since the topic has not been discussed in detail we shall keep it simple. So there were many
Open & high matches on the put side and thus there was a high probability that if the market
comes down then it would come down with momentum and hit these numbers.
The most important point to consider here is “Momentum”. In options scalping we consider
there is momentum only when there are two consecutive candles either Red or green with
corresponding volumes > 50 K.
Today there were many instances when the market started moving down but we didn't see 2
candles coming together.

We saw that the two candle setup never came and thus we never got the momentum on the
downside.
This just shows how beautifully this market was controlled.
To add to our surprise some Open and Highs were hit in the last 5 minutes of trading hours just
to satisfy some big players' ego.
So kindly note the importance of 2 candle setup and its relation with momentum.
Today the market was very well controlled by the sellers
Let us look at Active Strike dat for the day
We see that around 11 the difference in Active strike IV became around 8 the desired level for
an Option buyer. At this time PE IV was higher signifying that there are more PE buyers and this
was the time when market was near Day’s high. So it gave ample evidence that there is no
further up move envisaged and the market may turn downward anytime and it did.

During the rest of the day the IV difference came down and never increased beyond 8
suggesting that aggressive PE buyers were out of the system and that explains lack of any
downward momentum.
Towards end of day both IV’s spiked suggesting that there was some active buying going on.
Now with IV’s rising towards the end of the day we can assume that tomorrow morning this IV
spike will compensate for any Gap up or Gap down movement thus there is not much benefit in
taking any BTST trade.
Thus we saw that IV can give you many insights about the market.
In coming sessions we shall delve deeper into all these topics to help you connect all the dots

Regards
Team OI Pulse