Market Gauge

Rising implied volatility causes option prices to rise or become more expensive; falling implied volatility results in lower option premiums. Therefore, with everything else being equal, when implied volatility on an option is high, it is better to sell that option; If the implied volatility is low, the option more suitable for buying.

Relative value

To solve for implied volatility, option pricing models require:

• the option's expiration date
• the strike price of the option
• the price of the underlying asset
• the dividends paid
• the prevailing interest rate
• the current option's price
• style of options
• call/put

As mentioned above, when the option premium increases but the other factors remain the same, the change in option price is due to a change in implied volatility. Each option contract has a unique level of implied volatility, which can change over time and as the demand for an option rises or falls. To determine at any given point of time whether implied volatility is relatively high or low (i.e. whether an option is relatively cheap or expensive) it is important to compare the current value of volatility to the levels that existed in the past.

To derive a fair price for a particular option, the historical volatility is used. Often, though, the price that an option trades for on an exchange is different than the theoretical price, and the volatility that is used to derive the exchange price is referred to as implied volatility.

Implied volatility exhibits a skew since it is higher on options below the current price of the underlying security, than those above the current price of the underlying.

In practice, Implied Volatility is also the variable market makers play around with in order to make a higher profit on options that are suddenly in demand. This variability does not allow Black Scholes model to calculate implied volatility accurately.

Statistical Approach

Direct modelling of arbitrage-free evolution of an entire implied volatility surfaceremains largely unresolved. Unlike traditional models of spot dynamics, directimplied volatility models face increasing difficulty in enforcing no-arbitrage conditions,when multiple strikes are introduced at a maturity.
Instead of demanding no-arbitrage, the modeller may have a goal more statisticalin nature, namely to describe the empirical movements of the impliedvolatility surface. According to Cont and da Fonseca’s analysis of SP500and FTSE data, the empirical features of implied volatility include the following:
Three principal components explain most of the daily variations in impliedvolatility: one eigenmode reflecting an overall (parallel) shift in the level, anothereigenmode reflecting opposite movements (skew) in low and high strikevolatilties, and a third eigenmode reflecting convexity changes. Variations ofimplied volatility along each principal component are autocorrelated, meanreverting,and correlated with the underlying.

The independent research team in association with our analysts will continue to publish their research on this topic over time.