Understanding Implied Volatility for Trading

Sep 5, 2024

Lecture Notes: Implied Volatility by Kirk

Overview

  • In-depth discussion and workshop on implied volatility, crucial for options trading success.

Key Topics

  1. What is Implied Volatility?

    • Definition and significance in options trading.
    • Comparison with stock trading: Stocks have known company information; options include time and implied volatility.

  2. Determining Our Edge

    • Importance of implied volatility in trading.
    • Comparison to insurance companies' risk assessment and premium pricing.

  3. IV Rank

    • Identifying high implied volatility.
    • Using IV rank to compare relative implied volatility between different stocks.

Detailed Discussion

Implied Volatility (IV)

  • Definition: Anticipated future movement of stock prices.
  • Calculation: Based on the price of at-the-money and near the money options.
  • Market Participants Influence: Trader actions (buying options) determine future expectations.
  • Importance: Differentiates options from stock trading due to the time component.

Pricing and Market Expectations

  • High IV suggests a significant expected stock movement.
  • Low IV suggests a smaller expected stock movement.
  • Traders influence IV through option pricing.

Expected Range

  • Calculated using current stock price and implied volatility percentage.
  • Provides a probabilistic future price range (e.g., 68% probability range).
  • Example: For a stock at $50 with 20% IV, expected range would be $40 to $60.

Edge in Options Trading

  • Comparison to Insurance: Over-expectation of risk in pricing, similar to insurance premium modeling.
  • Market Overestimation: Market often overestimates the movement range, providing an edge for option sellers.
  • Long-term, stocks tend to move less than implied by IV.

Strategy for Options Trading

  • When IV is High: Larger positions (3-5%) due to greater market overestimation.
  • When IV is Low: Smaller positions (1-2%) to maintain positive returns.

Implied Volatility Rank (IV Rank)

  • Purpose: Measures current IV against historical highs and lows for a stock.
  • Application: Determine relative high or low IV for decision-making.
  • Example: Comparing Apple (tech) and GE (industrial) requires context-specific IV rank, not raw IV.

Practical Considerations

  • Software Tools: Use tools to calculate IV rank/percentile for better trading decisions.
  • Historical Data: Important to maintain and analyze for effective trading strategies.

Questions and Answers

  • Addressed user queries about IV calculation discrepancies and practical application.
  • Explained differences in IV calculation methods and their implications in trading.

Closing Remarks

  • Encouragement to engage with more workshops and Q&A sessions.
  • Emphasis on the practical application of implied volatility concepts for successful trading.