# Understanding Implied Volatility

## What is Implied Volatility?

Implied volatility is a measure of the expected volatility of an underlying asset based on the current market price of its options. It represents the level of uncertainty or risk investors perceive in the market. Implied volatility is an essential concept in options trading because it affects options prices.

Calculating implied volatility is a complex process that involves using an options pricing model, such as the Black-Scholes model. The implied volatility is the value that, when entered into the model, results in the theoretical value of the option equaling its market price.

## The Relationship between Implied Volatility and Options Prices

Implied volatility plays a critical role in determining options prices. Higher implied volatility leads to higher option prices, while lower implied volatility leads to lower option prices. This relationship is because higher implied volatility indicates that the market expects larger price fluctuations of the underlying asset, increasing the likelihood of the option ending up in the money.

On the other hand, lower implied volatility indicates that the market expects smaller price fluctuations of the underlying asset, reducing the likelihood of the option ending up in the money. Hence, the option's price decreases.

## The Volatility Smile

The volatility smile is a term used to describe the implied volatility for options with different strike prices but the same expiry. Options on most securities display the volatility smile, with implied volatility lower for strike prices near the current market price and higher for out-of-the-money (OTM) options.

The volatility smile is a result of market participants' differing perceptions of the risks associated with different strike prices. Options with strike prices near the current market price are more likely to be exercised, and hence, the market perceives them to be less risky. Conversely, options with strike prices that are far from the current market price are perceived to be riskier, leading to higher implied volatility.

## The Volatility Skew

The volatility skew is a similar concept to the volatility smile. The volatility skew describes the implied volatility of options with the same expiry but different strike prices. However, unlike the volatility smile, the volatility skew is asymmetric.

For example, in equity options, the implied volatility for options with strikes that are far below the current market price of the underlying tend to have much higher implied volatility than those with strikes far above the current underlying price. This skew is because the market perceives options with strikes far below the current market price to be riskier than those with strikes far above the current market price.

## Importance of Implied Volatility in Options Trading

Implied volatility is a crucial concept in options trading because it affects options prices. As an options trader, you can use implied volatility to:

Determine when options are cheap or expensive

Predefine trading conditions and know when to enter or exit a position

Identify potential opportunities for selling or buying options

Buy undervalued options and sell overvalued options

Determine which options strategy to employ

## Trading Strategies in High Implied Volatility Environments

Options trading strategies can be categorized into two categories: long premium strategies and short premium strategies. In high implied volatility environments, short premium strategies are more effective since options prices are higher.

Short premium strategies include:

Credit Spreads

Naked Puts

Short Straddles/Strangles

Covered Calls

In high IV environments, traders can sell options at higher prices than in low IV environments, improving their breakevens. For example, if an options trader wants to sell a put at the 95 strike with XYZ stock trading at $100 and the implied volatility is high, the strike may be worth $7.00, where the maximum profit is $700 if the strike expires OTM.

## Trading Strategies in Low Implied Volatility Environments

In low implied volatility environments, long premium strategies are more effective since options prices are lower. Long premium strategies include:

Debit Spreads

Naked Long Puts/Calls

Diagonal & Calendar Spreads

For example, if an options trader is looking to collect $3.50 in extrinsic value premium for selling a put and wants to take the stock if the put goes in the money (ITM), in a low IV environment, they could be at the $95 strike to collect that same $3.50 in premium. That means their breakeven for the shares would be $91.50, a full 5 points higher than the high IV environment's strike.

## Conclusion

In conclusion, understanding implied volatility is crucial to options trading success. Implied volatility is a measure of the expected volatility of an underlying asset based on the current market price of its options. It affects options prices and can be used to determine when options are cheap or expensive, predefine trading conditions, and identify potential opportunities for selling or buying options.

In high implied volatility environments, short premium strategies can be employed, while long premium strategies are more effective in low implied volatility environments. By understanding implied volatility and employing the right options trading strategies, traders can optimize their success.