Implied volatility and historical volatility are a very important concept to understand options trading.
To understand implied volatility options traders need to understand the key drivers of implied volatility. The implied volatility drivers are the extrinsic value of the stock option and the time left for stock expiry.
Extrinsic Value of the option
Comparing the extrinsic value of the stock option can tell us which stock have higher implied volatility.
- Consider stock A & B for the example
- The stock price for both stocks is 100
- Price of 90 strike call option for Stock A is 13
- Price of 90 strike call option for Stock B is 16
- The extrinsic value is = Option Price - (Stock price - strike price)
- Therefore Extrinsic value of A stock = 13-(100-90) =3
- Extrinsic value of B stock = 16-(100-90) =6
- Higher the Extrinsic value higher the implied volatility
- Higher the implied volatility large the stock move we expect
- Expiry time also impact the implied volatility
- If both options have the same extrinsic value but option A have 5 days and B have 10 days to expiry
- Option A has high implied volatility as compared to option B
Implied volatility tell us how market except the stock to move in future
Historical volatility tells us how the market behaved in the past.
Relationship between implied volatility and historical volatility
- Higher historical volatility = higher implied volatility of the stock options
- lower historical volatility = lower implied volatility of the stock options
If the stock historical volatility high we can expect large moves daily and there is more risk for the option sellers. Due to this option sellers demand more extrinsic value to sell the option because the option seller took a higher risk than the option buyers.
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