Implied Volatility: A Primer

Implied Volatility is fairly self explanatory.

However, conceptualizing it can be tricky.

Let’s take a quick look into volatility, implied volatility, probability, contract pricing models, memes, and a few things in between.

First off, some definitions.

Volatility: amount the stock price fluctuates.

Implied Volatility: forward looking potential volatility.

Historical volatility: the actual volatility of the stock, well, historically.

Stock falls: IV (typically) increases

Stock rises: IV (typically) decreases

IV rises: contract prices rise

IV falls: contract prices fall

The reason I say typically is because, on rare occasions such as an earnings report (or even pending covid news from POTUS) the stock can be rallying, and IV will be increasing, but more on that in another post, which you can find here.

Okay, cool. Dictionary defined, now what?

Implied Volatility is simply the probability that the underlying price will fluctuate +/-X% from where it’s at, over the life of the contract. Here, X% is simply just the Implied Volatility.

Say we have an example: AAPL, a low volatility stock, and GME, a stock whose options chains peaked at over 1300% IV during January 2021’s upward surge.

Let’s say, for measure, AAPL is currently trading at ~$175 a share right now.

Based on this chart, let's say the 30 day implied volatility for AAPL is currently 33.3%

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What's this saying: For the next 30 days, is that AAPL's price has a 68% probability (chance) of staying within 1 standard deviation of the current share price, and a 32% probability of exceeding that range.

No need to comment on my superb art skills; I know I'm good.

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But Falcon, what about per chain IV's or per contract????

The same logic applies.

When you see IV on a per contract or per expiration basis, it breaks down the same way.

For this week's expiration, an ATM AAPL call ~$175 has 48% IV.

You might be asking: Why is it higher? Shouldn't it be lower considering AAPL is more likely to expire close to that strike?

But why does IV increase into expiration?

It's due to how contract pricing is determined from a sell-side/broker side perspective (special thanks to a few folks who helped sort this out)

Short dated contracts carry more gap risk.

What is gap risk? Gap risk is where the underlying asset might receive an unexpected news catalyst, or market volatility could spike (re: covid news with lockdowns, new variant, rate hikes, etc.). As a result, sellers might end up being on the wrong side of these trades.

To counter, premium prices get bumped a bit relative to what they're actually worth, which makes the IV rise.

Fundamentally, this should not be the case.

A lot of brokers are still using Black Scholes to calculate their greeks and associated information external of contract pricing, so greeks between different brokers are more than likely different. Some use BSM, some use binomial trees, and some use Bjerksund-Stensland.

But what does this have to do with greeks?

Black Scholes was derived assuming returns are normally distributed, which research has since shown that they are not, and are likely lognormal. Resulting, greeks can get skewed on the outer tails of the distribution.

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So, there are two reasons why IV is read to spike into expiration.

That about wraps up part one of the IV series; I'll be writing more in coming weeks.

As always, please feel free to debate me on any points, (cage style ladder match fighting, too) as growth only happens in discussion.

Hope you learned something new today. If you have any questions, dm me on twitter https://twitter.com/falcon_fintwit