How Option Prices Affect Implied Volatility & Standard Deviation

[Music] everyone welcome back to the show happy Friday hopefully you all have a great Memorial Day weekend planned I'm going to talk about how option prices drive implied volatility today and how implied volatility drives standard deviation so we're gonna really break down the relationship between these three things I think there's a lot of great takeaways and a lot of misconceptions out there so we're gonna break all those down today and we're going to really break all these down and show you exactly what we're looking for when we're trading with options so let's start out with really defining implied volatility and how prices drive implied volatility a lot of people believe once you learn about implied volatility that implied volatility is something that we can actually find out or something that we already know without using any other options but that's actually not the case so with the black Scholes model we actually are taking all the other inputs of that black Scholes model and we're attempting to solve for implied volatility by using those inputs so price is probably one of the bigger ones so we're gonna focus on price today so if you believe and think about prices and how option prices change and how that reflects upon implied volatility it starts to make more sense so we know that option prices are made up of intrinsic value and extrinsic value intrinsic value is really just the real value at expiration so when options are in the money or when calls are below the stock price and when puts are above the stock price both of those scenarios are in the money scenarios and both of those scenarios have intrinsic value at expiration when I'm looking at a call option if I can buy 100 shares of stock for a lower price than this market is giving me right now that's going to have intrinsic value and with puts if I can sell option if I can sell shares of stock at a higher price then the market is giving me right now that's also going to give me intrinsic value but when we look at extrinsic value that is a number that is derived from time and volatility so the more time we have on an option expiration more that's going to be priced if you think about something like insurance which if we're looking at a long put against 100 shares of stock basically what we're doing is completely insuring the losses on those shares if we were to see them so what I'm doing with a put is if I were to buy that I would be buying insurance on my shares so the more I have the more days I have until that expiration of that contract it's going to be worth more so if I'm looking at a 30 day expiration and comparing it to a 60 day expiration the 60 day is definitely going to be worth more because I have insurance on those shares for 60 days rather than 30 but another thing that comes into play other than time is that implied volatility so when we're looking at solving for these metrics and solving for how these things change the option price what we really need to know is that the other way around so option prices Drive implied volatility so if there's a lot of speculation in a certain underlying maybe there is a big news announcement like you might see with earnings where earnings really tends to drive up implied volatility and you'll see it implied volatility rise around earnings because of that speculation so time doesn't change we're not really adding any time or subtracting any time but what does change is that speculation and we can wrap that around the implied volatility so when people are buying options if you think about it like supply and demand when people are buying options that's going to drive the price up of those options if people are selling options that's going to drive the price down just like the normal stock market so when we see options that are priced at a lower level we're going to see a lower implied volatility because of that because again with the black Scholes model we solve for IV using these other inputs but if we see the option prices starting to gain value and all other things are being held constant so if we're not seeing an increase in intrinsic value and there's really not much of a passage of time we can attribute that increase in the options value to an increase in speculation and because of that speculation increase we're going to see a larger implied volatility so when we're looking at implied volatility we're just thinking about what the implied move of that underlying is over a course of time so on the next slide we're actually going to talk about in applied volatility and we're gonna really break that down for you so really what we need to know when we're interpreting implied volatility from an options trading standpoint is just understanding that it is something that is implied we're not looking at historic volatility which is really a backwards looking metric where we're measuring how much that underlying actually moved we're looking at implied volatility which is forward-looking so implied volatility is the annual implied move of an underlying with a sixty eight point two probability of happening so that is one standard deviation sixty eight point two percent of occurrences when we capture that amount of occurrences we're capturing one standard deviation which we'll get into in a little bit but here I've got some examples for you so implied volatility here let's say we've got a stock price at 100 if I have an implied volatility of twenty percent then I would have a one standard deviation range of 80 and 120 so all I'm doing here is taking 20 percent of that stock price so the stock price is at 120 percent of that would be 20 points to the downside which lands me at 80 and 20 points to the upside which lands me at 120 so when we're looking at implied volatility this basically states that with a probability of 68 percent this underlying could potentially move between 80 and 120 if we have an implied volatility of 20 percent and that's for a course of a year so as you can see it's a pretty small value when we're looking at and thinking about how much an underlying can change in price over the course of a year twenty percent isn't too high but I want to compare it to a much higher IV at 50 percent so let's say we're looking at a different underlying that's trading at $50 a 50 percent implied volatility would indicate that this underlying could either lose half its value and go down to 25 or gain half its value and go up to 75 so this is a much higher implied volatility and one interesting thing I want to point out is that this right here is a 50 point range so even though this stock price is half the amount of this one we've got a 50 point range here and only a forty point range here so that's the power of implied volatility and when we see these high levels of implied volatility we're normally going to be seeing a higher priced premium in those options because the fact that this underlying could potentially or the implication is that it could move down to 25 or it could move up to 75 so because there is that speculation a lot of people are going to be buying options whether they're hedging their positions so if they're hedging long stock maybe they're buying puts and if they're hedging a short stock maybe they're buying calls or maybe there's just people out there that are speculating on these implied moves so they're just purchasing options which is going to drive up that implied volatility which is why you would see it at something level like this but really the key is understanding implied volatility in terms of standard deviation so if we think about implied volatility there's two metrics that we use to put contract context around that implied volatility number one and the most basic is IV rank so IV rank we're really just looking at the high of implied volatility over a certain time frame and the low of implied volatility and we're measuring where the implied volatility is at now so let's say we had an underlying that was and that had a low implied volatility of 50 percent and a high implied volatility of 100 percent so this is a pretty volatile underlying let's say right now that implied volatility is at 75 percent it's right in between that range which would give it an IV rank of 50 percent so that's one way that we can use an IV rank metric or an implied volatility metric to put context around implied volatility itself but what we really need to focus on is standard deviation and how that applies to option strikes so let's go into the next slide and we'll figure out how this all works together so when we talk about implied volatility really what we're looking at is that implied move of the underlying and standard deviation really is just a way to put context around implied volatility using those strike prices of the option chain so I've got some numbers here listed in the upper right corner which are very helpful to remember so when we're looking at one standard deviation if we're looking at options when they're out of the money or in the money we're looking for these probabilities here so if I am looking at probability of being out of the money if we're on the dope platform when I'm looking at one standard deviation I'm going to be looking for a strike price that has a probability of being out of the money of about eighty-four percent that's going to capture that sixty-eight point two percent range roughly because if we look at 84 percent out of the money that means it's going to have a probability of 16 percent being in the money because it's just the inverse of that so if we take 100 percent subtract 84 we get 16 and if I do that for the put side I've got a 16% chance in the money and I do it the same thing for the call side I have two options that have a 16% chance of being in the money I add that together that gets me 32 percent now what happens if we subtract 32 from 100 we get 68 so that's how we get that calculation of one standard deviation and how we really capture that one standard deviation range so using these numbers we can easily do that but really when it comes down to standard deviation it's just a quick way to put pinpoints in strikes and really visualize where these probabilities are and where these one standard deviation and two standard deviation ranges are so here I've got a low-volatility environment and a high-volatility environment so let's look at the low one first so our stock price let's say is trading right at 100 for both of these in a low-volatility environment if I'm looking at one standard deviation maybe my out of the money put strike would be at 95 so it's only 5 points out of the money but since it's a lower implied volatility it's going to come hand-in-hand with a lower probability of being in the money so when we're looking at that right here it's going to be the same to the upside let's assume let's pretend there's no volatility skew at all it's perfectly equal on both sides so I'm looking at one standard deviation to the downside at 95 and one standard deviation to the upside so if I'm looking at selling a call here let's say that one standard deviation line was at 105 so as you can see this one standard deviation range only covers a 10 point range so just knowing that right off the bat I can easily assume that this is a pretty low implied volatility level so really when we see implied volatility increase what's going to happen is we're gonna see these strikes go much further out for that same probability so when we're looking at one standard deviation to capture that same exact probability of whatever we're looking at so if I'm looking at out of the money I would look at for that 84% value so in a higher IV environment I might have to go all the way down to the 80 strike to reach that one standard deviation and all the way up to the 120 strike to reach that one standard deviation so this is how standard deviation works it really just gives us context around implied volatility from a strike price level and as you can see this range is only ten points where this range is a full 40 points so it's four times more just from a pretty big increase in implied volatility and we can get pretty close to probably the same values for these options in a low-volatility environment so let's say maybe I could get a dollar for selling this strangle here where I'm just selling a put at 95 and selling a call at 105 but in a much higher implied volatility environment I can maybe collect the same dollar but going much further out so I can I can sell the put at 80 sell the call at 120 collect that same value but really have a huge massive range of 40 points and that's the power of implied volatility and why we usually tend to sell premium in higher implied volatility but let's wrap all this together with some takeaways for you so the very first takeaway we've got is IV is a living breathing thing and therefore standard deviation is 2 when we look at underlyings will see implied volatility change so I want you to imagine when implied volatility is low those strikes and the standard deviation is going to get much closer to the stock price but when it's higher that's going to expand so the probabilities are going to expand way out into those out of the money options so every single day we look at it I want you to realize that implied volatility is changing but when we place an option and let's say we sold an option in that high-volatility environment we've got those strikes out here if implied volatility contracts our probabilities are going to contract as well but that's great for us because it's going to reduce the option premium in those options and if we sold that strangle if implied volatility contracts which really tracks that bell-curve what we're gonna see is we're gonna be able to buy back that spread hopefully for a much lower value and a profit and again option prices drive implied volatility not the other way around so it's really important to grasp that concept it's more about supply and demand rather than just looking at implied volatility and realizing oh that's what implied volatility is we're actually solving for implied volatility using other inputs and understanding this relationship as you can see it really helps us understand and realize when there's opportunity but also it helps us stay away from maybe inopportune moments so if we have super low implied volatility and I can go only get a few strikes away for that one standard deviation level I'll probably stray away and wait for a better opportunity so thanks so much for tuning in hopefully you enjoy this segment if you got any questions or feedback shoot me an email here or you can follow me at doe trader Mike we've got Jim Schultz coming up next though so stay tuned you

Channel: tastytrade

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Keywords: implied volatility, implied volatility options, implied volatility explained, options implied volatility, what is implied volatility, options trading, options trading implied volatility, trading, stock market, how to trade options, options trading for beginners, implied volatility options strategy, tastytrade, standard deviation

Id: 4ktNd2twSaQ

Length: 14min 24sec (864 seconds)

Published: Tue Sep 19 2017