Using the magic wand of IV or implied volatility can mean that
an option trader is using the edge of his setup to the fullest.
Understanding IV takes time and experience. And, paper trading
might not give one the idea of such practical case studies.
The IV is a dynamic concept and it rewards you to be on
the right side of it.
The option prices are basically composed of the intrinsic
value and the time value. The value is quite plain vanilla to
understand with respect to the underlying values of the option.
For the time value, it is to be remembered that one needs to
base it on the expiry day. The number of days to the expiry
will determine the time value of an option. The fateful outcome
of this option is that it decays and eventually perishes if it is
Out of Money. Time values can also factor in the strike price,
the underlying price, and even the interest rates.
By implied volatility values one can judge which side, the
market is expected to be likely headed. In terms of events
or special timings in the market, there can be an imbalance
or hyperactivity in the traders. This results in a change of
supply and demand and that creates the action. As and when
the demand for an option rises, the IV will also increase. So,
along with the high IV, the premiums also increase and one
needs to pay a higher price for the same options.
It is important to note that the Implied volatility can fall
sometimes so much that it becomes difficult to even
trade them. Traders and investors who are looking for
a quick return always prefer volatility and a good IV is
always better than none. The ebbs and the tides of the
Time value can determine the relation of time value to
an option price.
Check out this option strategy for buyers and sellers
A buyer of an option, even when they are right about the
direction of the underlying can lose money due to the
low implied volatility. Because with low implied volatility
the prices of the options don’t seem to increase at all and that
leads to lower returns and often negative returns. As the buyer
is suddenly fighting Implied volatility along with the time values
against them.
Another interesting point to note here about Implied volatility
is that there are certain options that will react differently to the
same values of the implied volatility. A long-dated option will be
more prone to the effects of an IV than a short-dated option.
This is because a longer time frame option will have a significant
cushion of time value as well. A trader news to be really careful
of the interpretation of the IV, as it may not have the same impact
on the underlying across similar events. The dynamic nature of the
IV can be understood through extensive studying and backtesting.
Once a trader aces the learning of these parameters it is much
easy to understand the movement and make money out of it easily.
Deep learning is always rewarding in the market. However,
some indicators can be handy too. An indicator can foreshadow
and perhaps mirror the sentiment that is there inherently in the
minds of most traders or investors. Volatility indices like the INDIA
VIX and the CBOE Volatility Index (VIX) are good indicators of
Implied volatility is not a constant idea and it can have multiple
interpretations as well. Anybody seeing the charts can see that
the IV is either low or high and come to a different conclusion.
For some buying an option for cheap and selling it higher
can be a good alternative. Many techniques are used for this
reversal technique. Traders expect that the curves will turn up
high again and there will be opportunities to see higher prices
in the future. The idea becomes simply to sell when the IV chart
shows a rise and find opportunities at a lower IV value. The
trends or cycles of the market can be pre-empted based on
past charts and stringent analysis. The laborious efforts might
improve one’s trading significantly and can easily provide an
edge without many complications. The concept of selling
overvalued assets and value-buying optimally priced instruments
is a good technique to compound money over a period of time.
The implied volatility is the secret sauce for that strategy.
Understand the concept of carrying forward.
While it is almost impossible to catch the tops and the bottoms of
any market, it is almost pretty straightforward to determine whether
an option has the highest or the lowest volatility. One can check the
values from the options chain itself and see if an option has the
highest or the lowest values. Many use this study to play the
strategy that, eventually markets will revert to the mean. So a
high IV will cool down and a lower one will get steam soon.
It has to be kept in mind that, just before an important event like
financial results, dividend announcements, or any other significant
global or company-related news that instrument will have a higher IV.
Or, to put in other words the IV of the options of that instrument will
see significant moves based on the market expectations. It is quite
easy to figure that once the events are over, the IV will obviously
crash and cool down. The idea for a trader should be to be on
the right side of these events.
Option selling becomes a good strategy in the case of high implied
volatility scenarios. Credit spreads or short straddles can work well in
case of a high implied volatility situation. The idea is to sell the options
when the buyers are anyways out of the mood to pay such high premiums.
On either hand, low Implied volatility means that long straddles and debit
spreads will work better. However, on the contrary, it should also be meant
that sometimes due to momentum traders, an option with a relatively high
IV will continue to trade even higher as time passes by. So, the one with
a low Iv will eventually be crushed further.
This article is meant for education only, always maintain a trading
journal and consult your financial advisor before investing.
Read this to understand about volatility index
Learn more about the margin trading facility
and the leverage trading options.
Margin Trading, Deep OTM & ITM
Not all strategies work all the time, however, it makes a lot
of sense to understand the concept of volatility and use it
to your benefit.
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