In options trading, traders frequently deal with volatility, especially implied volatility (IV), which is displayed on Pi42’s Options Trading page. This article explains IV, helping you understand and anticipate future price fluctuations of the underlying asset, and how to use IV when trading options.
IV plays a key role in option pricing and can be viewed as an alternative way to value options contracts. Accurately predicting IV is essential, as it directly impacts your potential profit and loss.
Basic Concepts: HV and IV
Historical volatility (HV) of an underlying asset can be used to analyze its volatility over a period of time.
- Implied volatility can predict possible movements in the price of an underlying asset. IV indicates how traders in the Options market perceive the volatility of the underlying asset.
Note: Please note that both HV and IV are presented to traders at an annualized rate.
How IV Affects Option Prices
Option premiums consist of two parts: Intrinsic value (in-the-money) and time value (out-of-the-money). The intrinsic value depends solely on the difference between the underlying asset price and the option’s strike price, and isn’t influenced by the Greeks.
Implied volatility (IV) mainly affects the option’s time value. The sensitivity of an option’s price to changes in IV is measured by vega, which shows how much the price will change for every 1% shift in IV.
To know more about Greeks , read here
All other factors equal, the higher the IV of an Option, the greater the possibility of the underlying asset's future volatility — and the higher the Option price will be.
Example
Suppose Trader A holds the following BTC Call Option:
Current BTC price: 100,000 USDT
Strike price: 105,000 USDT
Higher price fluctuations in the underlying asset increase the chances of the price moving beyond 105,000 USDT, making options more likely to be profitable for buyers. If the underlying price rises but remains relatively stable, a call option may still expire worthless if it doesn't exceed 105,000 USDT, and the buyer loses the premium.
As an option buyer, you benefit from more volatility, while sellers prefer stable prices.
Greater fluctuations lead to higher implied volatility (IV), which means a higher likelihood of profit for buyers and increased option prices.
IV and Expiration Time
Implied volatility (IV) impacts option prices differently depending on how far they are from expiration. The longer an option has until expiry, the more IV influences its price. As the expiration date approaches, price uncertainty decreases, so IV has less effect and options are priced with less volatility risk.
IV and Strike Price
Typically, implied volatility (IV) is lowest when the strike price matches the underlying asset price, and increases as the strike moves further away—creating a “volatility smile” pattern.
This happens for two main reasons:
IV varies with different strike prices, and the further an option’s strike is from the current market price, the greater the chance for big price moves, increasing IV.
Out-of-the-money (OTM) options can suddenly become in-the-money (ITM) due to sharp price swings, making it harder for sellers to hedge. To offset this risk, OTM options have higher IV.
The volatility smile is more pronounced for options nearing expiration, while longer-dated options have a flatter curve.
The Black-Scholes model assumes normal volatility, but in reality, the likelihood of the price hitting the strike is often underestimated, pushing IV higher than the model predicts.
Finally, IV is influenced by actual trading between buyers and sellers, market expectations, trading volume, and open interest. This means real-world volatility curves don’t always follow a perfect arc, and the lowest point of IV may not always be at the at-the-money strike.
Assessment of IV level
If IV reflects the market’s expectation of future price movement, it can be either overvalued or undervalued. Typically, when IV is higher than historical volatility (HV), IV is considered high; when IV is below HV, it’s considered low.
HV is usually calculated using past price data (e.g., over 20 or 60 days). During sudden market swings, HV might lag behind real-time volatility, making it much lower than IV. Using shorter timeframes or intraday data can capture recent volatility more accurately, though it may sometimes overestimate future movement.
If an option’s at-the-money (ATM) IV is above both its long-term and short-term HV, it’s likely overvalued—this could be an opportunity for short vega strategies like a short straddle. Conversely, if IV is well below both long- and short-term HV, it may be undervalued, and long vega strategies like a long straddle could be considered.
Here are some Options trading strategies for your reference:
How to Trade Options With IV
You only need to select IV Mode on the Option order page to place your order directly according to the IV.
Please note that placing an order based on IV — that is, your order price — will change with the price of the underlying asset and the expiration time of the Option.
Conclusion
The IV is an important indicator for traders to assess whether an Options price is reasonable. If you think that the future price volatility of the underlying asset is much lower than the expected IV, you can consider shorting the IV and vice versa.
When trading IV, there are some common volatility trading strategies (mentioned above) you can consider. Alternatively, you can also consider dynamically hedging your delta while trading IV to keep your position “delta neutral” at all times. This requires you to have trading software that satisfies this function, in addition to continually monitoring the change of your delta value.
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