Have you ever seen two different stocks at very similar prices, and then compared their options and noticed one stock has option contracts for nearly twice as much as the same option contracts, with identical strikes and expiration dates, but for the other stock? One of the key reasons for this difference in options pricing is Implied Volatility, a fundamental part of understanding options. Today, we'll be learning all about Implied volatility.
What is Implied Volatility?
Implied Vol. , or IV is a measure of the market sentiment for the change in a certain stocks price, as implied by option pricing. In other words, IV represents the expected magnitude of potential changes in a stocks price. The number you see when looking at Implied volatility represents the expected percentage change in a stock's price in one year, as implied by the prices of the stocks options. For example, say Stock A is currently at $100, and has an IV of 50. This means, in one year, the expected price of stock A is between $50 and $150. ($100 * 0.50)+/- $100. To find the price range in one year based on IV, use this formula. The current stock price + (the current stock price * IV %), for the high end of the range, and the current stock price- (the current stock price *IV%), which is the lower end of the range. It is important to know Implied Volatility represents the expected 1 standard deviation range for a stock's price in 1 year. 1 standard deviation represents 68%, meaning there is an approx. 68% chance the stock will end up in the calculated IV range. For the example above, this means there is an approx. 68% chance that Stock A will end up between $50 and $150 in one year.
How does this relate to options? Option prices represent the general market sentiment towards a certain stock. Higher option prices means buyers are willing to pay more for the options of a certain stock, as they are expecting larger changes, or more volatility, in the underlying stocks price. A larger change would allow for more profit if the price moves in favor of the options buyer, therefore buyers are willing to pay more. The more buyers are willing to pay, the higher the options price goes, which increases the implied volatility of the underlying stock. The opposite also applies. Cheaper option prices means less expected change in the underlying stock, which means less potential for profit, and a lower IV.
We can see this in the example below.
At the time of this article, dollar tree, ticker DLTR had an IV of %56.32, and was at $81.73. Addus Homecare, ticker ADUS had an IV of 77.56% and was at $80.35. As you can see, both stocks have similar prices. Now, if we look at identical options for both stocks, we can see a massive price difference. A may 15 2020 Call option for Dollar Tree, at an $80 strike price is going for $560. The same option, a may 15 2020 Call option at an $80 strike price, but for Addus Homecare is going for $750, 134% of the identical option for dollar tree. This shows the correlation between IV and options pricing.
In short, if a stock is expected to change in price a lot, its options prices go up, which leads to higher IV, which represents the larger expected movements.
It is important to remember IV does not only represent a positive change in the stock price, it shows the potential for any change, meaning it also represents a possible decline. As shown in the example, an IV of 50 means there is an approx. 68% chance the stock price would increase or decrease 50% in one year.
To calculate the expected 1 standard deviation price range for a stock in a certain period of time (other than 1 year) based on IV, the formula is (stock price *IV) * (the square root of the number of days/365).
For example, if Stock A has a price of $100 and an IV of 50, and we want to calculate the 30 day 1 standard deviation range, we can multiply the stock price, 100 by the IV, 0.5 , and multiply by the square root of 30/365. Once we do this, we get 14.33. This means that in the 30 days, there is a 68% chance stock A will be between $85.65 and $114.33 based on the current implied volatility.
IV is a percentage which shows the expected 1 standard deviation range for a stock in one year, based on options prices.
There is a direct relation between market sentiment and IV, as market sentiment is one of the factors that determines options pricing, which in turn determines IV.
Higher IV means more expensive options prices, and lower IV means cheaper option prices.
Thank you for reading, and I hope you now have a solid understanding of Implied volatility and its relation to options pricing.