What is Implied Volatility and How it effects Premium Prices?
Implied volatility is represented by IV and is available in all option chain on NSE Website.
This will help you understand the chain:
The picture shows IV in the Black box for SBIN stock.
IV Basically tells you how much a buyer is willing to pay extra to buy an option.
Both Call (CE) and Put (PE) have Implied volatility and the value of IV determines how much will be the premium for each strike.
Consider the example to understand in a more detailed way:
There is a stock X whose CMP is 100 and we are watching a few strikes for the call as well as put.
Let’s say Implied volatility is around 20 for all the strikes (Hypothetical assumption)
And there is another stock Y which is also at CMP 100 and we are watching a few strikes for the call as well as put.
Let’s say Implied volatility for this stock is 30 for all strikes (Hypothetical assumption)
This means in past Y has been more volatile than X and also it is expected to be more volatile in future and hence the premium pricing of Y would be greater than X.
Since Implied volatility is based on current market price, expected market outcomes, historical performance, and time for expiration, there is no specific formula to calculate IV as such.
The only way to calculate it is by backtracing it from the real-time Premium value of each strike.
All values are known and IV is unknown we add all values to backtrace Missing IV
All values + IV = 20
All value : 10
So by backtracing it
We get IV = 10.
Similarly, we put all values in the Black-Scholes formula and get IV by checking premium prices and back-tracing it from the blackscholes formula.
As shown in fig.
We know that there are a buyer and a seller involved in every transaction.
Higher the volatility, more the swing on either direction and hence more probability of an option buyer getting an advantage due to it, or rather it would discourage a writer to short any options.
To counter this risk, a writer demands extra premium proportional to Increase in IV.
For X and Y stock mentioned above, we know that the probability of Y moving up/down is higher than X because IV of Y is greater than X.
Now, as an option writer, I would be more comfortable in selling CE/PE of X rather than Y
Because I know Y might move more aggressively than X.
If as a seller I want to sell Y, I Would rather ask more premium from buyers to take that extra risk.
That means :
100 CE of X might be at 4 rs premium
100 CE of Y might be at 6 rs premium.
This extra 2 rs demanded by Seller is for the extra risk he is willing to take.
Thus Higher the IV higher the premium.
The major impact of this is during events :
Example: On normal days NIFTY has IV in range 14 – 18,
During election results, it went up to 50+.
That means if CMP of Nifty is 11900
On normal days 11900 CE/PE would have cost 100 rs but due to election
Same 11900CE/PE will now cost 230rs (Approx)
And if the event is over,
And Nifty remains at 11900,
IV from 50 would drop to 14 – 18
And in a day 11900 CE will become 100.
So these 130 points fall in a day is not due to time decay, its rather drop in IV.
Thus IV is also one of the major factor deciding the premium of Options.
We hope this helped you.