The rate at which security rises and falls is measured by volatility. Volatility is high when a security moves swiftly up and down. In contrast, volatility is low when a security moves slowly up or down.
Historical volatility (also known as realized volatility) is a recording of how the underlying really moved over a set time period, whereas implied volatility is a measure of what the options markets predict volatility will be over a given period of time (until the option's expiration).
Implied volatility meaning: For two reasons, implied volatility (IV) is one of the most crucial concepts for options traders to grasp. For starters, it indicates how volatile the market may become in the future. Second, implied volatility can aid in probability calculation. This is an important aspect of options trading that can help assess the possibility of a stock reaching a certain price by a certain date.
While these factors can help you make trading decisions, implied volatility does not provide a market direction forecast. Although implied volatility is considered a valuable piece of information, it is calculated using an option pricing model, which makes the data speculative.
One approach to grasp implied volatility is to compare it to its polar opposite: historical volatility. Historical volatility, unlike IV, is a measure of what has actually occurred with an investment. It calculates the yearly average of a security's daily price fluctuations.
Historical volatility can be a useful tool for determining the risk level of a stock or option, as well as anticipating implied volatility. However, previous volatility does not guarantee how an investment will perform in the future.
An option buyer pays a premium that is proportional to the market's predicted volatility. Contrary to popular belief, counterparties in illiquid option transactions negotiate implied volatility rather than price. Analysts also use IVs as a gauge of overall market sentiment. Each contract has its own IV, which is shown on exchange sites and terminals.
The IVs of at-the-money (ATM) Nifty options - those with strike prices closest to the spot – are generally followed by analysts.
Traders that are pessimistic like to buy put options as a hedge. This raises the IV of put options, indicating bearishness. Similarly, when traders do not protect themselves vigorously against strong market changes, their IVs fall. The majority of traders are comfortable with IVs of 20% to 25%. Since traders are not expecting any events that could trigger volatility, IVs on ATM Nifty options have recently decreased to roughly 14%.
Implied volatility levels, in theory, do not indicate market direction and so do not necessarily indicate bearishness. High IVs, on the other hand, are frequently interpreted as a bearish indication by traders.
They claim that the expectation of a downturn has a greater impact on trading behaviour than the expectation of an upturn. High IVs are almost always a sign of bearishness, as investors and fund managers try to protect themselves from a rapid drop.
These are the major benefits of implied volatility:
The market's forecast of a security's price movement is known as implied volatility. IV is frequently used to price options contracts where high implied volatility leads to higher premiums for options and vice versa. The primary influencing elements for estimating implied volatility are supply and demand and temporal value.
If implied volatility rises, the price of options will rise in lockstep, assuming all other factors remain constant. As a result, when a transaction is entered, implied volatility rises.
As implied volatility is embedded in an option's price, and options pricing model formula must be rearranged to solve for volatility rather than price (since the current price is known in the market).
A high IV indicates that the market anticipates significant changes in the current stock price over the following 12 months. A bearish market occurs when equity prices fall over time, making long-term bullish investors more vulnerable. Implied volatility is expected to rise in this type of market.
The disadvantages of implied volatility include:
1) It is not only based on prices nor on market fundamentals.
2) It has an impact on implied volatility in the event of unpredictable occurrences like natural disasters.
3) Predicts movement rather than direction.