Implied and historical volatility ploted on a graph

Implied Volatility

Implied volatility (IV) is the estimated future volatility of a financial instrument as priced by market participants.

As you recall, when pricing an options contract’s premium days preceding expiration, there is an additional element to time value called implied volatility.

An options contracts premium could compared to pouring a beer to a glass. What will happen if you pour carefully a cold beer close to the glass edge? The result will be a nice cold beer and little or no froth. Now what will happen if you pour warm beer far from the glass edge?  The result is a glass filled with little beer and the all the rest will be froth (I will not argue about the taste). If you will wait long enough and all the froth vanishes, the amount of beer you will see left is very little.

Implied volatility is the froth and the beer is the real value (the theoretical value). Warm beer resembles the markets uncertainty, and pouring far from the edge resembles the markets turmoil. Thus if you buy options during times of uncertainty and turmoil you will get to have little beer and much more froth, and if you wait enough you will see that there is not much left after a short period of time even if you are right about the direction

On the contrary, buying options when the market is converging (getting cold and quiet) you will get more of the options contract’s fair value (more nice cold beer). The chances to win are in your favor. When getting into a long options position look first how much of fair value you get and how much is the froth.

Calculating implied volatility: According to the B&S model, a theoretical price takes under consideration the underlying historical volatility.

To calculate the IV, for the sake of simplicity we will not delve into the formula and its components. To carry out the calculation is to gradually change the volatility factor (measured in percentage points) in the options theoretical pricing model. The change will be in small values to fill the gap between the options contract’s theoretical value and the actual market price difference (measured with money).

If the gap is negative, the new volatility calculation reflects small reductions (this means, IV reduced since last calculation) and if the gap is positive, calculation increases with small increments (this means, IV increased since the last calculation).

Symbol; QQQQ's historical data collected from Nov05h 2005 to May06 2006.
Dotted Line refers to 30 days Historical Volatility and the Solid line refers to IV.

If you study the plotted graph above, you will discover that the IV line changes very quickly compared to the historical volatility (dotted line). From mid-November 2005 to the end of December 2005 the volatilities difference increased, after the actual spiked up at the start of the year 2006, IV decreased in values up until March 2006. At this time both lines converged to their lowest reading in the given time interval; from Mar 2006 to April 2006 no changes in the dotted line but in the solid line increases in value. From April 2006 to May 2006 both lines increase in their values.

IV is forecasting the HV: from this graph, if you will study similar graphs, you will encounter this phenomenon.  As mentioned before, market participants are studying their alleged instruments (this particular one is 'QQQQ') and have an idea that, in some point in the near future, something will happen with the instrument they are monitoring and are therefore willing to pay more than its fair value sometimes much more. Most of the time they are right and something does actually happen to the underlying instrument.

Thus, when you analyze an instrument and you see that its IV starts to rise and keeps gaining in value, this should send a signal to you and you should get ready to act. Timing is definitely the name of the game; as I mentioned before, buying an option with a lot of froth (expensive) will not always lead to profit, and on the other hand, one who sells the froth gets to keep most of it. In addition, you may notice that IV reading value is above the HV reading. In all other IV / HV analysis that you will encounter in the future, you will notice that most of the time IV reading value is higher than HV; the lines grow apart and then converge almost in a mirrored sinusoid-like manner.

If you decide to buy or sell on the graph, probably December 2005 will be appropriate time to sell options, and from the end of February 2006 to the start of April 2006 would be an appropriate time to buy options.