Lurking under the surface of the stock market, the options market can provide a lot of insight about how day traders feel about the future of the market. Many day traders, even those who don’t trade options, pay attention to signals derived from options pricing.
One of the most popular of these signals is implied volatility. Here’s a look at implied volatility and what it says about the market right now.
Implied volatility is a simple concept to understand even if it is slightly complex to calculate.
The basic idea of IV is that options prices inherently include an estimate for how much the underlying stock price will move by the expiration date. In other words, the options market will automatically adjust based a stock’s potential future price.
IV does not measure whether a stock will trade up or down ahead of an option’s expiration date, only how much it may trade up or down by.
The idea that higher IV means larger potential swings in share price is a relatively straightforward and useful idea. Any calculation of IV, however, must incorporate an option pricing model, such as the popular Black-Scholes model. Solving for implied volatility using Black-Scholes yields the following formula:
Fortunately, traders don’t need to solve the equation and can simply rely on an online source to calculate it for them.
Large spikes in IV can be a red flag that something is going on with a stock even before the stock’s price starts to react. Since IV is forward-looking, it’s a measure of option traders’ expectations of where a stock price could be headed. Since there is no directional component, IV is often considered to be a fear or uncertainty gauge for a stock. The lower the IV, the more confident options traders are that the underlying stock will remain relatively stable, likely continuing its most recent trend.
A high IV is a signal that options traders expect a disruption ahead. That disruption could mark a fundamental event, such as an earnings report surprise, or it could mark a technical trading event, such as a trend reversal.
Some traders may have been using IV and option market trading signals already without even realizing it. The CBOE’s Volatility Index, or VIX, is a measure of the forward 30-day volatility of the stock market based on at-the-money put and call options prices for S&P 500 index options.
The VIX is essentially the IV of the entire S&P 500, and spikes in the VIX can tell traders a lot about how worried options traders are about what’s coming.
Since the end of September, the VIX has spiked more than 60 percent while the S&P 500 has dropped 6.3 percent. The VIX has recently pulled back from its October highs, but it remains at its highest level since early April. Stock prices bounced back in at the end of October, but the elevated VIX suggests options traders aren’t convinced the market is out of the woods just yet.
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