How is options implied volatility for a stock determined?

[lcruz007]

Hi,

For any give stock, in TWS (and on any other broker) there is a reported options historical volatility and an options implied volatility. I know the historical volatility is the annualized standard deviation of the stock. But how is the implied volatility determined?

I am aware that the implied volatility is the volatility the market expects in the future. But how far in the future? i.e is it the implied volatility using options that will expire in one year? Is it the implied volatility using options of expiry of one month? Is it determined using at the money or in the money options?

I don't need to know the mathematical model used (if it's based on black scholes or not), I basically just would like to know some general information about how the stock's IV is determined. i.e What options with what strike prices and expiry dates are used to determine the IV.

Basically I would like to know the following... After I know there are cheap options based on low implied volatility percentile, how should I proceed to buy the option? Since there are many options with different IVs, which option should I buy? The one with the closest IV compared to the one of the stock? Or what?



Thanks in advance.

 

[options-george]

I will have a quick go and answering some of your questions.

However, at the outset, I would advise you to undertake further study before starting to trade options. There are lot of things one needs to understand with options.

IV is based on the volatility anticipated by the market makers. The level of volatility will vary depending on the time horizon. Hence why all options have different levels of volatility.

Additionally options with the same expiration date but different strike prices will also have different IV levels. Generally speaking, ATM options will have lower IV and OTM options will have higher IV. Plotting IV vs strike prices on a graph will therefore generally give you a "volatility smile".

When people talk about IV levels, they generally referrring to the IV of ATM options.

The VIX index for example is calculated on a mix of IV levels for various ATM options.

Your questions in the last paragraph, IMHO, require a lot of discussion to answer fully. Hence I why suggest you still complete further study before starting to trade options.

Hope that helps & good luck!

 

[lcruz007]

I will have a quick go and answering some of your questions.

However, at the outset, I would advise you to undertake further study before starting to trade options. There are lot of things one needs to understand with options.

IV is based on the volatility anticipated by the market makers. The level of volatility will vary depending on the time horizon. Hence why all options have different levels of volatility.

Additionally options with the same expiration date but different strike prices will also have different IV levels. Generally speaking, ATM options will have lower IV and OTM options will have higher IV. Plotting IV vs strike prices on a graph will therefore generally give you a "volatility smile".

When people talk about IV levels, they generally referrring to the IV of ATM options.

The VIX index for example is calculated on a mix of IV levels for various ATM options.

Your questions in the last paragraph, IMHO, require a lot of discussion to answer fully. Hence I why suggest you still complete further study before starting to trade options.

Hope that helps & good luck!

Thanks for your reply George, it does help a bit.

The thing I am struggling the most right now is in regards to my last question though. I know there are plenty of factors that will affect my decision on what option I should buy. On my case, I am planning on using a delta-neutral and positive vega strategy, possibly with a long straddle. Therefore, I am looking for the stocks with the most cheapest options (historically) and my broker gives me a number (the IV) and then I determine the IV percentile based on where the IV has been historically.

I am also combining this strategy with a sentiment indicator, so when I determine there is a stock with cheap options AND that I predict there will be volatility in the future with the sentiment indicator I enter a trade. At this point I am unsure on what to do. Should I look for longer term options which are more sensitive to vega? Should I look for options that have IVs close to the value I got from the broker (the reported IV for the stock? etc etc...

Do you have any suggestions about this? If you know an article or something that I could read about this, that'd be great. If not, any type of guidance would be greatly appreciated!

 

[options-george]

Thanks for your reply George, it does help a bit.

The thing I am struggling the most right now is in regards to my last question though. I know there are plenty of factors that will affect my decision on what option I should buy. On my case, I am planning on using a delta-neutral and positive vega strategy, possibly with a long straddle. Therefore, I am looking for the stocks with the most cheapest options (historically) and my broker gives me a number (the IV) and then I determine the IV percentile based on where the IV has been historically.

I am also combining this strategy with a sentiment indicator, so when I determine there is a stock with cheap options AND that I predict there will be volatility in the future with the sentiment indicator I enter a trade. At this point I am unsure on what to do. Should I look for longer term options which are more sensitive to vega? Should I look for options that have IVs close to the value I got from the broker (the reported IV for the stock? etc etc...

Do you have any suggestions about this? If you know an article or something that I could read about this, that'd be great. If not, any type of guidance would be greatly appreciated!

Hi again. Glad it helped a little bit.

Unfortunately I can't help out more at this point. I think your questions validate a lot of discussion and I am not able to formulate a quick simple answer for you. But maybe others on the forum can.

O-G

 

[Windlesham1]

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[Windlesham1]

http://optionsinvesting.co.uk/trade-week-8-time-get-strategy/
Have a look I have done a step by step calculation using iVolatility.com