Volatility is both the best friend and worst enemy of traders; without it, in tranquil markets, it is very difficult to turn a profit or find good trade opportunities, but when volatility spikes it can throw even the most carefully planned strategy off course. Options are used to hedge against volatility, so increased volume in the options market shows that an asset is either experiencing or is expected to experience soon, increased volatility. Implied volatility is a measure of that expected volatility, and is part of the formula that goes into options pricing models. There is more than one way to confirm volatility expectations with options; volumes, spreads, and open interest all work too, and are quicker and often more effective than attempting to calculate IV.
Implied volatility
Implied volatility is a key metric in the Black-Scholes model used to calculate the price of (European-style) options. To calculate implied volatility, we insert the other inputs in the Black-Scholes formula and backfill the figure for implied volatility. The Black-Scholes formula relies on five inputs: strike price, current underlying price, time to expiration, risk-free rate, and implied volatility.
The formula itself is complicated, and calculations using it are often done automatically using a spreadsheet with entry points for each input. Traders don’t need to worry too much about the calculations involved unless they plan on building their own options pricing models. However, traders should know that implied volatility is calculated by inputting other data into the formula and working back to produce the final value.
Some of the assumptions involved in this formula are questionable, but since options traders worldwide all use the same set of assumptions this is normally ignored by the markets. Volatility is absolutely crucial to the trading of options, which exist to profit off and hedge volatility, to the point that options traders are sometimes called ‘vol traders’.
Other measures of volatility
Other fortunately simpler methods exist for measuring volatility. One of the quickest yet most effective is to look at open interest and total traded volume of options, a metric which increases when volatility is expected to increase, and decreases when traders foresee tranquil markets. These numbers are easily accessible on trading platforms and give traders a good headline overview of what is happening in the markets.
The cost of options is also directly linked to volatility; when far out-the-money options are more expensive, that is because the market expects that prices could go to these distant levels soon. For example, many traders will hedge against a catastrophic slump in a market by buying far out-the-money puts in small quantities, normally for very low prices. This can cap or reduce the losses in case of a sudden downward move, but when very many traders are all attempting to make the same hedge, the price of these options increases noticeably. If you see this pattern emerging, it may be time to adjust your stop losses and prepare for market volatility.
Remember options volume spikes may happen for other reasons – old options could expire and be renewed, the news can temporarily influence market sentiment, alongside many other possibilities.
Are these methods accurate?
Interestingly, some academic financiers are sceptical about the effectiveness of implied volatility as a measure of future volatility in comparison with other methods. One study involved reviewing eight years of market data from 2012-2020, and found that historical volatility was a better predictor of volatility over the next month than implied, although both were able to provide some degree of prediction.
Given many techniques used in trading stubbornly refuse to be ‘confirmed’ by academic finance, it is reassuring that both implied volatility and historical volatility can provide statistically significant predictive power. Traders looking to get an estimate of future market volatility should use both of these methods to ensure they are prepared.
Future volatility and trading strategies
Let’s say that you are a swing trader, making many small trades on either side of the main trend. Future volatility expectations, especially in the forex market, do not tell you whether the market is going to move up or down – for stocks this is a different story, since equities volatility nearly always means price decreases – but does let you know how large and sudden future trends may be.
An increase in volatility coming after a long, stable trend can also indicate a reversal, so this is a good moment for contrarian traders or chartists looking for reversal candlestick patterns to practice extra vigilance. You can trade expected volatility in a similar way to volume – look for divergences between the trend and the volatility trend, and don’t be afraid to act quickly once an opportunity appears.
On the other hand, every market can see mysterious expected volatility spikes that never translate into the real thing – perhaps a big news announcement is coming up, and options traders get spooked before settling down. Apply the same common sense filters as you would for any other trade.
Volatility and risk management
If any leading metric for volatility such as calculated implied volatility, open options interest, or trade volume increases, you need to check your risk management is up to the challenge. When the options market sounds warnings price fluctuations are on the way, it is wise to bring up stop losses, ensure you do not have any oversized open positions, and that your portfolio allocation is on point.
Sudden volatility can trigger stop losses, so in many situations it is best to move them up to breakeven when volatility is expected to rise. For example, imagine you opened an AUD/USD long trade at 0.625, and the current rate is 0.640. If your TP level is 0.645, and you place a stop loss at 50% of your expected profit to ensure a 50% hit rate for profitability, the original stop loss will be 0.615. Now imagine that open interest in AUD/USD puts is increasing, historical volatility is ticking up and implied volatility indicates you could see sudden moves in either direction in the coming month.
A trader in this situation could leave his position at it is; a considerably larger downward move would be required to stop it out than the positive one required to take profit. If he were very nervous about volatility, or feared the trend was about to reverse, he could close out the position at the current profit levels. Alternatively, an option between the two levels of risk aversion would be to move the stop loss to 0.625, meaning that the maximum potential loss for the trade is zero. This still gives the potential for the trade to reach its planned take profit level, while removing downside risk.
Conclusion
Retail traders should look at volatility as an opportunity, but one that can bring risks to even a well-balanced portfolio. Luckily, there are multiple indicators that allow us to detect volatility spikes before they happen, including implied vol, historical vol data and options pricing / volume. Checking these metrics will allow technical and fundamental traders to better understand what conditions they might be dealing with in the coming months, and to make the necessary risk management adjustments to protect their gains.
How Rakuten can help
Implied volatility is a complex but helpful calculation that allows you to price options effectively. If you want to test out your knowledge, why not open a free demo account and start trading today without risking any of your capital?