What is Implied Volatility?
Implied volatility is a prediction of how much the price of a security will move over a given period of time. It’s most often used to price options contracts. This is the single most important factor that decides whether you will make money in the trade or not. Therefore, it is important to understand this concept carefully.
Implied volatility measures how much a security’s price is likely to move up or down in a specific period of time.
The price you pay for a premium is crucial to a trader’s profitability.
- A CE/PE or Call/Put option buyer can win the game only when it buys it at a low premium. It is possible only when the IV is low.
- A CE/PE option seller can earn a profit when IV is high so that you get a higher premium as a credit.
Implied volatility is the most important concept in options trading and every trader should understand it properly, else you can never become a Pro. It’s the soul of options trading.
Therefore, if India VIX is 18 percent, it means the price of underlying can change up to 18% during the contract period. Here it is to be noted that India VIX is the volatility index.
Importance of Implied Volatility?
Implied volatility tends to be on the higher side when the market is expected to fall sharply due to a black swan event or any other event. And when the fear reduces the market premium for options decreases sharply and IV goes down. If you buy or sell options at the right IV, there is a good probability that you can make money or lose less even when you are wrong.
- As expectations rise, or as the demand for an option increase, implied volatility will rise. Therefore, a naked option buyer should never buy when IV is high.
- As the market’s expectations decrease, or demand for an option reduces, and IV decreases.
The concept is simple: Low IV ensures you buy an option cheaper. Since the option contract expires at zero at the end of the contract. The low premium ensures you don’t lose much when you are wrong.
- Debit strategies usually work better in low IV conditions.
- Credit strategies usually work better in high IV conditions.
- Avoid credit strategies in low IV conditions.
- Debit strategies are better avoided in high IV conditions.
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