Implied volatility is arguably the most important factor for options trading. This week, we discuss how to interpret implied volatility. We also show why you should not use implied volatility as an absolute measure.

Indicative volatility?

If you input the spot price, the strike price, time to expiry and the risk-free rate into a Black-Scholes-Merton (BSM) calculator along with the actual option price for the given strike, you will get the option’s implied volatility. This is the volatility that is implied in the option price.

Consider the 23000 next-week Nifty call. With the Nifty Index currently at 22989, the option’s implied volatility is 27.82 per cent. Arguably, the implied volatility indicates the market participants’ expectations of future volatility of the underlying. So, an implied volatility of 27.82 per cent indicates that the market expects the Nifty Index to move up or down 27.82 per cent in one year with a probability of 68 per cent. In other words, the implied volatility represents the annualised volatility of the underlying. The probability is based on the normal distribution for a one standard deviation event. The assumption of a normal distribution comes from BSM model, which is used to derive the implied volatility.

Of course, knowing the annualised volatility is not useful. You want to know the expected volatility during the life of the option. Again, assuming normal distribution, you can determine that number. The number of trading days in a year is approximately 256 and the number of trading days for the next-week expiry option is eight. To convert annualised volatility to period volatility, you must divide the implied volatility number by square root of 256. This gives you the daily volatility. To determine the eight-day volatility, multiply the one-day volatility by square root of eight. The resulting number is 4.91 per cent.

Empirical evidence suggests that implied volatility is not a good indicator of actual volatility (also called as realised volatility). This is because of two factors. One, implied volatility is a function of the demand for a strike. Greater the demand, higher the implied volatility. So, keeping other factors driving an option price constant, an increase in demand will push the implied volatility. But it may not be an indication that the market expects the future volatility to increase. And two, volatility changes with time. This change in volatility (risk premium associated with volatility) means that implied volatility is typically greater than actual or realised volatility.

What to do
Traders could go long on the strike with the lowest implied volatility, as this factor is part of an option’s time value, which decays with each passing day
Optional reading

It is optimal to apply implied volatility as a relative measure than an absolute metric. So, instead of looking at implied volatility to understand future volatility, it is better to compare implied volatility across tradable strikes (the ATM, immediate two OTM strikes) of a given underlying for a given maturity. You could go long on the strike with the lowest implied volatility, as this factor is part of an option’s time value, which decays with each passing day.

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