In trading, it’s impossible to know exactly how a stock or security will perform in the future. There are simply too many variables.
A time machine sure could help, but we’re all still waiting for that to become a reality. In the meantime, you need smart tools to help you make smarter trades.
As a trader, you want to build an intelligent thesis for every potential trade. One of the tools that can help you in this task is the implied volatility indicator. This indicator can offer a projection of how a security’s volatility might look in the future … no crystal ball required.
Let’s take a closer look at implied volatility, including what it is, how to calculate it, and how you can use it in your trading.
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Implied Volatility Definition
So, what’s implied volatility? In short, it’s a math-based estimate of the future volatility in a security’s price. It’s expressed as a percentage.
To really grasp the concept, it’s important to understand what volatility is first …
Here’s a quick refresher: Volatility refers to how quickly a security’s price moves.
That movement can be in either direction — up or down. So, if a price is moving very quickly, it’s considered highly volatile. If it moves slowly or not very much at all, the volatility is considered low.
Also note the term ‘implied,’ which is used due to the fact that this number is a guess about what can happen in the future. Yes, it’s based on a number of mathematical factors, so it’s not just a random guess. But it’s important to remember that this number can never be certain.
How to Calculate Implied Volatility
What do you need to determine this magical implied volatility percentage?
Implied Volatility Formulas
There’s more than one way to calculate implied volatility. Here are a few …
Black-Scholes model: Despite what you might think from the name, a trio of economists — Fisher Black, Myron Scholes, and Robert Merton (Merton is sometimes tagged in the title) — devised this formula in the early 1970s.
These economists created this model to calculate implied volatility and determine theoretical options prices.
The calculation takes into account things like the market price, the price of the underlying asset (since options are a type of derivative, their price is derived from an underlying asset), the strike price of the option, the interest rate, and the date of expiration.
This formula is popular. Many view it as sparking great interest in options trading from the ‘70s on. In fact, in the late ‘90s, the developers of the formula received the Nobel Prize in economics!
It’s very important to note that fancy math aside, even the Black-Scholes model isn’t beyond reproach …
Some people take issue with the fact that it factors in constant volatility. And as you probably already know, even the most volatile stocks can have periods of inactivity or sideways/neutral movement.
The binomial model: Here’s an alternative to the Black-Scholes model. The binomial model calculates the volatility potential in scenarios with both an upward and downward price movement.
It plots the movement in both directions over time and can help you see what might happen to the volatility in multiple scenarios.
When you calculate the implied volatility using the binomial model, the chart looks like a tree branching out in the different potential directions. Many traders like this model because it accounts for more than one direction of price movement.
Implied Volatility Versus Historical Volatility
How different can implied volatility and historical volatility be? After all, they’re both types of volatility, right?
That’s true, and it’s also true that the difference between the two is fairly simple. But it’s an important difference.
Historical volatility (also called realized volatility or statistical volatility) refers to a security’s past volatility. You can determine historical volatility by looking at a stock’s past performance and scanning for big price swings.
The good news here is that you can count on this data as factual. The bad news is that a security’s past performance won’t necessarily continue with similar volatility in the future.
Implied volatility, on the other hand, considers the past volatility, but tries to apply the data to figure out what might happen in the future. This number is not factual — it amounts to an educated projection. So it’s not a frivolous number, but it also can’t be counted on.
Using Implied and Historical Volatility
With historical volatility, you can look at the past and try to make predictions about the future. While there are no guarantees, history is known to repeat itself, so it’s worth looking at what the security has done in the past to see how it might perform in the future.
Implied volatility plugs a few more things into the mix to try to make a projection for how a security might perform in the future. Think of it like a number that’s adjusted for inflation or something similar. It tries to factor in elements to see what might happen in the future.
How to Trade Options
Since implied volatility is an indicator most closely associated with options, let’s take a minute to discuss precisely what options are.
Options are a type of security that get their value from an underlying asset or assets, such as stocks, bonds, or commodities, which puts them into the category of derivatives. The option’s price will go up or down along with the value of the underlying asset.
Like stocks, derivatives can be traded on the major exchanges and on the over-the-counter (OTC) markets.
With options, you’re making an agreement to buy the asset or assets in question if it meets certain criteria. Maybe you want to buy 100 shares of a stock — but only if it reaches $50 per share. So you create a contract that if the item in question reaches your desired price within a finite period of time, you have the option to make the purchase.
To gain this option or right, you stake a claim on the trade by paying a premium, which is like a down payment.
When the expiration date comes, you can choose whether to exercise the option. But you don’t get your down payment back.
There are two types of options contracts: call options (where you buy) and put options (where you sell).
Earnings and Options
How is it possible to generate earnings from options trading? Here’s a basic example of how it might play out …
Let’s say you purchase a call option to buy 100 shares of a stock for $50 each. If the price actually goes up to $90 per share each, you can still get the agreed-upon price. You can then turn around and sell your shares for a profit.
Implied Volatility and Options
Why is implied volatility so important when it comes to options?
Options are speculative in nature. So, in pursuing options trading, you’re betting on a change in a stock’s future price, either up or down, depending on your position as a buyer or seller.
Implied volatility plays a role in determining an option’s price because it tries to project the volatility or speed of the price movement in the future. Implied volatility tries to predict this and build it into the price. The idea is that it can help set an appropriate and hopefully fair price.
Implied volatility isn’t just limited to options, though. It can impact other rates, such as figuring out an interest cap (that puts a cap on how much an interest rate can be raised over time).
Remember: Implied volatility is an educated guess, but it’s still a guess. There’s no telling what can happen in the days ahead.
Implied Volatility Trading Strategies
Ready to learn more on how to put implied volatility to work in your trading? Here are some strategies for using it …
#1 Is the Implied Volatility High or Low?
It don’t mean a thing if it ain’t got that swing!
In options trading, you want to get an idea about a stock’s potential future price swings. Swings in either direction can create opportunities, so you want to try to figure out — to the best of your ability — the likelihood of movement.
So, be sure to take the time to look at the implied volatility. Is it high? Is it low?
Implied volatility can help you predict a stock’s big price swings. If a stock or option has a high implied volatility, this can be a sign of a potential big price change in the future. And low volatility can indicate that the price will hold fairly steady.
Here’s something important to keep in mind, though: Implied volatility does not tell you the direction of the swing. It doesn’t tell you whether the potential volatility will cause the spike to go up or down.
#2 Check the News
No indicator, including implied volatility, is a stand-alone reason to buy or sell. You need to build a case for your trade by doing as much analysis and research as you possibly can.
So when you’re considering a security, be sure to back up your implied volatility number with thorough research on the company.
Look at the news and the general trend of the company’s recent earnings reports. Are there any events that caused the stock to move, or that could again? For example, if a company regularly debuts new products at a particular trade show, which results in the movement of the stock price, that can be a further indication of increased volatility in the future.
It’s not just about the company either. You need to consider world news, too. For example, something like Canada’s legalizing marijuana might not be directly tied to one specific stock or security, but that event caused huge price movements throughout the sector.
Stock screeners can be helpful here, too. On StocksToTrade you can view relevant headlines right on a ticker’s page, so you can get clued in on news catalysts!
#3 High Implied Volatility Means Sell
A very high implied volatility is usually a signal for traders that it’s time to sell.
Implied volatility is used to calculate options prices, so a high percentage makes for higher premiums. This means that for traders who want to avoid these big premiums, it can be more enticing to sell than to buy.
When does implied volatility tend to be higher? During a bear market. This is because the general mood is conservative, and people think that stock prices will drop.
#4 Low Implied Volatility Means Buy
A very low implied volatility can usually be a signal for a trader that it can be a good time to buy.
Low volatility makes for inexpensive premiums, which can make it more enticing for traders to buy. This is when a lot of traders will go long so that they can hold them with the hope that the volatility will increase later on in the contract.
When does implied volatility tend to be lower? During a bull market. The general market mood is optimistic, and people are more willing to buy and be excited about it.
Take Advantage of StocksToTrade Features
Do these calculations sound confusing? Good news: Implied volatility is automatically calculated on an options table.
Options? Yes indeed. Implied volatility is most closely associated with options trades, where you’ll see implied volatility listed either as “VOL,” “IV” (the Roman numeral four), or “σ” (the Greek symbol sigma).
StocksToTrade doesn’t currently have an implied volatility calculator (yet … stay tuned!), but the platform is equipped with plenty of indicators that can help you look at a security’s historical volatility. That can help you make educated projections about future volatility.
The StocksToTrade platform has just about every indicator you need to help you make more intelligent trades. Come and test out your favorite indicators — and learn some great new ones — with a 7-day, $7 trial.
Conclusion
It’s not possible to know precisely how a security will perform in the future. However, the implied volatility can give you a reasonable, data-based indication of what type of movement might occur in the future.
By considering a security’s implied volatility, you can gain insight about its potential future performance. While the implied volatility can’t be counted on as an absolute, it can help you formulate smarter trading plans and focus on securities that fit your desired criteria.
Of course, like any other indicator, implied volatility is only one piece of the puzzle. It’s important to consider a variety of technical indicators and perform detailed fundamental research on any security before entering a trade.
How do you use implied volatility in trading decisions? Leave a comment and let us know!
