Options are traded widely in exchanges, but it may seem very complicated at first, especially if you are a new investor. However, once you understand how it works, it becomes easy to invest in options and diversify your portfolio with a new asset class. So, how to invest in options?

An Option is a  contract that lets you buy/sell an underlying asset over a specific period. However, the value of an option depends on several external factors. One such influencing factor is implied volatility.

What is implied volatility or IV?

It is the possible forecast of movement in the price of a security. Implied is an important word here — the term is all about what the market suggests the volatility of a stock may be in the future.

Implied volatility means that market can move in any direction, upward or downward. It is influenced by many factors like supply and demand, fear, sentiment, or actions of the company. It rises when the market is bearish, and investors’ sentiment is low. The opposite happens when the market is bullish; IV reduces significantly.

Why is it so important to understand implied volatility? 

Whether used to diversify a portfolio, generate income, or leverage stocks, options are a popular choice and have certain advantages over other investment tools. But its price is highly volatile and impacted by implied volatility. To understand it better, let’s first understand how an option price is determined.

Options prices have two main components – time value and intrinsic value. The intrinsic value (or inherent value) is the price difference in the market. Suppose you own an option for Rs 50, which has a current market price of Rs 60. You can then buy it at a lower cost and sell for a higher price to realise a profit. The intrinsic value of the option is then Rs (60-50) or Rs 10.

The other component is the time-value, which rises or diminishes with implied volatility.

Implied volatility reflects a change in demand and supply dynamics in the market. It is expressed in percentage format. If there is a rise in demand for the underlying option, IV will increase. And, it will increase the premium on the option too.  Similarly, its price will fall if IV declines.

Each option has a specific sensitivity to implied volatility. Short-term options are less impacted by IV, whereas, long-term options, since more sensitive to market changes, have higher IV sensitivity quotients. Your chance to successfully conclude the deal will depend on how correctly you can predict implied volatility changes.

But, is implied volatility the only influencer of options prices?

Of course not. There are other measures like historical volatility and realised volatility. Historical volatility, as the term suggests, is indicative of a change in the prices of an asset over a specific period in the past, typically, a trading year. It is based on past returns and can’t be relied upon heavily. Realised volatility is the volatility that will or has occurred. It is calculated from the underlying movement of prices. Realised volatility refers to what you get or realise, while implied is what you pay. There’s a future realised volatility and a past realised volatility.

So, how does implied volatility affect options? It can be understood better if we know how market factors change the perception of option prices. Some big news on the economy, company, or court verdict can influence investors’ perception of market trends. It is not changing the intrinsic value of the option but altering its time value – making a long-term option pricier than a short-term one.

How can you use IV to trade successfully?

A successful deal on options means being on the right side of forecasted IV. Let’s see with an example. Think of a call option with an underlying asset that’s trading at Rs 100; strike price at Rs 103 and premium at Rs 5. If implied volatility is 20 per cent, the expected range for the asset underlying is 20 per cent above the trade price right now, and 20 per cent below. This means the range of IV in this scenario is 80-120,

Implied volatility is also used to hedge a cash position. So if an option’s current IV is relatively lower than the IV for a whole year, you can buy options at a low premium and watch till the IV goes up. When IV goes up, the option premium value also goes up, thus pushing the overall value of the option up.

You can plan an option trade using implied volatility. How? Look at the way the market is moving. If an option is trading with high volatility, you can position yourself to sell. As IV rises, the option premium becomes costlier, they no longer remain a good buying choice, and you can then plan a sell. Implied volatility helps you understand the range between which the option price is likely to move. If you ask an expert, he too will tell you to plan your entry/exit on the cues received from an IV chart.

In the market, options prices move fast. And since options prices depend on the future market movements, it is highly unpredictable. Implied volatility is a good measure to understand and include market volatility into your trading plan.