What is Implied Volatility in Trading?
Most beginners find it very difficult to grasp just what the implied volatility of an option is, and how it is determined. I trust that the following will clarify the situation for most of you.
It is not necessary for us to understand the complete process of how market makers establish their initial bid/ask quotes and how those quotes are changed during the trading day. But do know that each market maker is required to publish a bid and ask price for each option he/she trades. This feat is accomplished via computer. In other words, the MM enters all the parameters that he/she wants to use when determining the value of an option, and the computer calculates the bid/ask quotes.
For the following discussion, assume that options on a specific a stock are trading today for the first time. Assume that these options are expected to attract a decent number of buyers and sellers because it is a "hot" stock that recently had its IPO (Initial Public Offering).
There is little trading history on this stock and thus very little volatility data. Marker makers do not have solid evidence for estimating the future volatility of the stock. However, they must make such an estimate. The computer program used to generate bid/ask quotations requires a volatility estimate for the underlying stock.
Market makers will not be using the same volatility estimates on that first day of trading -- and those estimates can vary over a wide range. So, when market makers first publish their bid and ask prices, it is reasonable to expect some difference of opinion.
Market makers (MM) who bid high prices will buy options from others who use a lower volatility and establish lower prices. The point is that it does not take very long for equilibrium to be established. If one MM is bidding $2.50 for a specific option and every other trader is selling that option, the bid will decline quickly. It will decrease until there are no more sellers. [Sure, this one MM may want to buy a huge number of contracts and keep the bid high, but that is an unreasonable expectation.]
When market makers are neither buying from, nor selling to, each other, equilibrium is established. Now the market makers will be trading primarily with customers (you and me as well as institutions). At equilibrium, the bid/ask quotes represent a consensus quote -- for that specific moment in time.
Disturbing the equilibrium
When the quantity of options to buy or sell becomes larger than the market makers (along with anyone else who is actively trading the options) want to buy at the bid price, or sell at the ask price, then the bid/ask quote ("the market") changes.
- When there are too many options for sale, that causes the bid price to be lowered. Perhaps by one penny -- perhaps by five cents, perhaps by some other increment. Once that previous bid disappears, then whoever is bidding the highest price (and it may be a market maker or anyone else) has his/her bid showing for the world to see. For example, when market makers collectively buy 1,200 (for example) call options at the bid price, that bid disappears (if no one else wants to pay that price) and the next highest bid appears, along with the quantity wanted (i.e, the size of the bid). Sometimes the current seller refuses to drop his selling price and the new market is established: the current seller's ask price becomes the published ask price. At other times, the seller 'hits' the new bid and sells at that price. This process of selling at the bid price continues until once again, equilibrium is established. That happens when the seller runs out of options to sell or when he/she is no longer willing to sell at the current highest bid price.
Note that the equilibrium may last for quite a while or disappear quickly.
- When there are too many options to buy, the effect on the ask price is similar.
Defining Implied Volatility
Regardless of how often it happens, those equilibrium periods do occur. Let's focus our attention on those times. There is not enough trading activity to change the markets and the bid/ask prices hold steady. Let's also assume that the underlying stock price remains unchanged during these times.
If the bid/ask midpoint price is taken as the "consensus" fair value (for that moment in time), then it is easy to look at a computer and read the current volatility estimate for that option. That "current volatility estimate" is the implied volatility for that option at that moment in time. [This may seem unrealistic, but if this is new to you, accept the fact that each option has its own individual volatility estimate and that a single volatility estimate for the underlying stock is not something used in the modern world.] Historical Note: When options first traded on an exchange (1973), market makers used a single volatility estimate for all of the options for a given stock, as long as they expired at the same time.
Each different expiration (and there were only three of them in those days; three months apart) has its own volatility estimate.
Market makers (i.e., the computers that generate the quotes) can and do update their volatility estimates frequently -- either manually or by use of an algorithm. In other words, when we accept the current market price as the true fair value of any option, then the volatility estimate used to establish that fair price is (by implication) the "correct" volatility estimate. Hence the term: implied volatility.
Simply stated: The current option price (premium) represents fair value because the current volatility estimate (implied volatility) is the correct estimate.
Most professional traders learn to accept that implied volatility as accurate (or nearly accurate) and make their trades based on current prices. This is a sound plan. I learned (the hard way) that betting that the estimated volatility is correct and that the implied volatility is wrong (in other words that the options are badly mispriced) -- is a losing strategy. In other words, a previously published volatility estimate is far less useful that the combined opinion of each of the traders who are actively trading the specific options.
When implied volatility feels wrong to a trader, it is possible to construct hedged positions that "buy volatility" when IV is low or "sell volatility" when IV is high.