Trade Options Using Implied Volatility5 min read
New traders often overlook volatility. Options are driven by volatility, which can be both a risk and an opportunity for traders. With the right understanding of the options, traders can profit from changes in volatility, as volatility is meant to reverse.
What is Implied Volatility (IV)?
IV measures the expected volatility of the price of an underlying asset in the near term future and is used to calculate the option price, i.e. the premium. IV and options premiums are directly proportional to each other; a higher IV leads to a higher option premium, and a lower IV leads to a lower option premium.
When the IV and premium are high, traders sell options to make money, and when the IV is low, options traders prefer to buy options. This is possible because an options trader can buy a call option or sell a put option for a stock that is trending up. Now, whether the trader buys a call or sells a put depends on the IV to a large extent.
But the catch is, there are some high beta stocks that are more volatile by nature, and their IV remains high perennially, whereas, in the case of low beta stocks, it may be the other way around. For example, for a typically volatile stock, when should the IV be considered high and when should it be considered low? The Implied Volatility Percentile, or IVP, a derivative of IV, comes to our aid here.
How to read the Implied Volatility Percentile (IVP)?
IVP measures the relative value of implied volatility. Irrespective of the actual IV numbers, if the IVP is 90, it is considered a high IV. Similarly, if the IVP is 20, regardless of the stock’s actual IV, the IV is considered low. It is measured on a scale from 0 to 100.
IVP of 0 to 20 is regarded as extremely low IV, 20 to 40 is low, and here, traders look for buying options. IVP above 80 is regarded as extremely high IV, and traders typically look for selling options.
Strategies based on IV
1. Long Straddle
A straddle is an options trading strategy that involves buying both a call option and a put option on the same underlying asset with the same strike price and expiration date. If the underlying asset moves significantly in either direction, the trader can profit from one option while the other option will expire worthless. However, if the price stays constant then both options will expire worthless, resulting in a loss for the trader.
2. Short Straddle
Here, as opposed to a long straddle, the trader sells ATM call and put options with the same strike price and expiration date on the same underlying asset. This is done when IV is high and expected to come down in the coming days. For instance, the IV was seen to be extremely high the day before the budget day, and as the budget presentation progressed, the IV and premium began to decline.
3. Long Strangle
Just like a straddle, a strangle is also an options strategy that involves buying both a call option and a put option on the same underlying asset, but at different strike prices. Buying an OTM call and an OTM put with the same expiration date.
Traders employ this strategy when IV is low and a significant move in the market is expected, such as before the US Fed’s rate announcement. The strategy also allows traders to pay a lower premium than a long straddle, but markets must move significantly in either direction to cover the premiums. This strategy is risky because both options will expire worthless if the underlying asset stays unchanged. Similarly, a short strangle is entered when IV is high, expected to contract, and prices are expected to stay in range.
Cons of Long Straddle & Long Strangle
The disadvantages of these strategies are the high cost of long straddle & strangle, and the higher risk in the case of short straddle & strangle. A trader may opt for Long Iron Fly or Iron Condor instead of long straddle and strangle.
4. Long Iron Condor
A long iron condor is an options strategy that involves buying a call option and a put option with the same strike price and then selling a call option with a higher strike price and a put option with a lower strike price (as shown in the fig. below). The two sold options have the same expiration date as the bought options. This significantly reduces the cost of the strategy.
5. Short Iron Condor
A short iron condor is an options trading strategy that involves first selling an OTM call option and an OTM put option, and then buying an OTM call option with a higher strike price (higher than the sold call) and an OTM put option with a lower strike price (lower than the sold put). All four options contracts have the same expiration date. This strategy is based on the trader’s expectation that the asset’s price will remain in a range.
Here is an example of Short Iron Condor strategy when Nifty was trading at 17400.
Trading options based on volatility requires a good understanding of options, asset fundamentals, and macroeconomic scenarios. Before using any strategy, it is important to weigh its potential rewards and risks. Options can be an effective instrument for trading volatility with the correct approach and risk management.
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