Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2022-11-28T13:50:35+05:30

Introduction

Investing in the stock market can be risky. The risks are due to the constant fluctuating values of securities. Factors like socio-economic conditions, management decisions, technological innovations, and business ecosystem, etc determine the fluctuations. An investor always wants to minimize risk and maximize returns on their investment. 

The best way to achieve it is to study the company’s past performance and make calculated predictions for the present and the near future. Another way is to stay abreast with the latest developments and make appropriate decisions. Also, there are several ways to do that using measurements and indicators derived from mathematical models. 

But can anyone predict future events and their effect on the investments made? Although there are no guaranteed methods, some concepts and their applications help investors to estimate the future and minimize risks to optimize gains.

This article explains concepts like volatility, Implied Volatility (IV), related terms and their application in trading. 
 

What is Implied Volatility (IV)?

The volatility of a stock price means the frequency with which the price changes over time. In the case of stocks, the higher the volatility, the higher the risk. Historical volatility is the variation of the stock price from its standard price in the past. This information is useful for predicting the performance of the stock in present and future.

Equity derivatives are securities that determine their value from the underlying assets. Equity Options and futures are important examples of equity derivatives. The performance of equity derivatives is determined by speculation and expectation in the underlying stock’s performance. A slight change in the stock performance causes a greater fluctuation in the equity derivative. This makes derivatives more volatile than equities. This fluctuation expected to happen in future is measured as Implied volatility.
 

Key takeaways

Implied volatility predicts the movement of a security’s price.
●    Options contracts are priced based on implied volatility. The higher the implied volatility, the higher the option’s premium, and vice-versa.
●    Implied volatility is calculated based on supply, demand, and time values.
●    The value of IV increases in a bearish market and decreases in a bullish market.
●    Implied volatility may convey market sentiment and uncertainty, but its calculation is based on prices rather than fundamentals.
 

Implied Volatility meaning and function

Implied volatility is a metric used to predict fluctuations in the prices of securities. It is a forecast made by the market based on predictive factors. It is a typical indicator of risk associated with security and is expressed in the form of percentages and presented as a range of values for a specific time.
In the stock market, Implied volatility increases in a bearish market when share prices are expected to fall over time. In a bullish market, IV decreases as volatility falls, and prices are expected to increase over time.

IV cannot predict the direction of the price fluctuations. A high IV can mean a big fluctuation in prices, but it cannot be said with certainty if the price will rise high or fall low. It means that it can greatly fluctuate between the range.  Low IV means the fluctuation is low.

Implied volatility and Options

Implied volatility is used to calculate the premium price of an option.
The external and internal business factors determine the volatility of a stock. This impacts the trading of options determining its supply and demand in the market. Implied volatility is influenced by the expected share price volatility and the option’s performance. If the shares are volatile the premium on the options will be high. It means the implied volatility is high. 

In the same way, if the expected volatility is low, the implied volatility associated with the options will be low, in turn reducing the premium on the options. The rise or fall of the implied volatility will determine the price of the option’s premium and hence their success.

Implied Volatility and Options Pricing Model

Implied volatility is calculated using the Options Pricing model. However, one cannot deduce it directly from market observations. The mathematical options pricing model uses other factors to determine the implied volatility and options premium. The two models used are described below:

●    Black-Scholes Model

In this Options Pricing model, current stock price, options stock price, time until expiration and risk-free interest rates are used in a formula to arrive at the options prices.

●    Binomial Model

This model uses a tree diagram to create different options prices at different points in the options contract. Volatility is factored in at every level to determine the different paths the options price can take. The benefit of this model is that you can backtrack to any point in the diagram in case of an early exit. Early exit is when the contract is exercised before its expiration.
 

Factors affecting implied volatility

The major factors affecting implied volatility are demand and supply. If the demand for an asset is high, its price will tend to remain high. This increases its implied volatility increasing the option premium as the risk associated with the asset is high.

If the supply is high and demand is low, then the IV tends to fall, thereby reducing the options premium.
The Time value of an option also determines its implied volatility. Short-term options tend to have lower implied volatility, whereas long-term options have higher implied volatility. In the long-term options, the price has more time to move to a favourable level compared to a short-term option. 
 

Pros and Cons of using Implied volatility

Pros

1.    Implied volatility helps to quantify the market sentiment of an asset.  
2.    It can be used to calculate the price of options.
3.    It helps in having a trading strategy.

Cons

1.    Implied volatility does not predict the direction of the movement. It cannot predict if the prices will rise or fall.
2.    It is sensitive to external factors like news and events since it is purely speculative.
3.    IV solely depends on the price and does not use fundamentals.

Real World Example

Charts are graphical representations of the price and volume movements of a stock over time. Investors and traders use charts to study implied volatility. The Cboe Volatility Index (VIX) is one such chart that presents a real-time market index. The VIX index is a chart representing near-term price changes in real-time of the S&P 500 index.  Investors can use the VIX to compare different securities to know the stock market’s volatility.
 

Why is Implied volatility important?

There are no definite means of predicting the volatility of derivatives in the future. The implied volatility revealed through the pricing of options is the closest one can get to predicting future volatility. This forms the basis of trading options. The trader can buy or sell their options depending on their analysis of future volatility and compare it with implied volatility.

How is implied volatility computed?

The current price of the option is known. In the options pricing model formula, one can substitute the value of the current price of the options and find out the implied volatility since all the other values are known.

How do changes in implied volatility affect options pricing?

The options price is directly proportional to implied volatility. If the IV is high, then the premium on the options will be high. When the market expectations decrease, the fluctuations in the options price will decrease. This means the market is less volatile and implied volatility has reduced. This will decrease the premium value of the options.

Conclusion

Implied volatility is a dynamic figure that changes in real-time based on the activity in the options market. It is the only metric that gives a trader or investor some idea about the volatility in the future. Predicting the future is difficult yet IV attempts to make that and aid trading decisions. The choice of an option is as important as the time of closing the contract to make a successful trade.  

In such a dynamic situation, when one is dealing with volatile instruments, implied volatility becomes an important metric to the investor. If the implied volatility of an option increases after the trade is executed it is profitable to the option buyer and a loss to the seller. The opposite is true if IV decreases after executing the trade. This way the IV becomes important to both the buyer AND the seller. 
 

Open Free Demat Account

& get benefits worth 2100*

Resend OTP
Please Enter OTP
  • Have Promo code?
  • Use code ACT2100
Enter Promo code
Account belongs to

By proceeding, you agree to the T&C.