How Does Implied Volatility Impact Options Pricing?

Options are derivative contracts that give the buyer the right, but not the obligation, to buy or sell the underlying asset at a mutually agreeable price on or before a specified future date. Trading these instruments can be very beneficial for traders for a couple of reasons. First, there is the security of limited risk and the advantage of leverage. Secondly, options provide protection for an investor's portfolio during times of market volatility.

The most important thing an investor needs to understand is how options are priced and some of the factors that affect them, including implied volatility. Option pricing is based on the likelihood that the underlying asset will finish in-the-money (ITM) or with some intrinsic value. The greater this likelihood, the pricier the options contract. Several factors come into play that affect the probability of this outcome; for example, with more time to expiration, the chances of a profitable expiration increase, along with the price of the options.

Volatility is also positively correlated with an option's price since the greater the price movements of a stock or other asset, the more chances those large moves will produce an in-the-money option. Because of this, volatility plays a key role in pricing options. At the same time, market participants can look to an option's price in the market and back out the implied volatility (IV) that traders expect the underlying to move.

Learn more about options and how volatility and implied volatility work in this market.

What Are Options?

Options are financial derivatives that grant the holder (the buyer) the ability to buy (in the case of a call) or sell (in the case of a put) the underlying asset at an agreed price on or before a specified date. Holders of call options seek to profit from an increase in the price of the underlying asset, while holders of put options generate profits from a price decline.

Options are versatile and can be used in a multitude of ways. While some traders use options purely for speculative purposes, other investors, such as those in hedge funds, often utilize options to limit risks attached to holding assets.

In order to successfully use or trade in options, however, one should be able to accurately price these rights.

Options Pricing

An option's price is often referred to as the premium. The option seller (known as the writer) is paid the premium by the buyer, who is granted the right to buy (or sell) described above in return. The buyer can either exercise the option or allow it to expire worthlessly. The buyer still pays the premium even if the option is not exercised, so the seller gets to keep the premium either way. Thus, the price of the option is linked to the chances the buyer will be able to exercise the option for a profit.

Consider this simple example. A buyer might pay a seller for a call option granting the right to purchase 100 shares of Company X's stock at a strike price of $60 on or before May 19. If the position becomes profitable (i.e., Company X stock rises above $60), the buyer will decide to exercise the option. If, on the other hand, it does not become profitable, the buyer will let the option expire worthlessly, and the seller gets to keep the premium. 

There are two parts to an option's premium: the option's intrinsic value and time value (extrinsic value). The intrinsic value is the difference between the underlying asset's price and the strike price. The latter is the in-the-money portion of the option's premium. The intrinsic value of a call option is equal to the underlying price minus the strike price. A put option's intrinsic value, on the other hand, is the strike price minus the underlying price. The time value, though, is the part of the premium attributable to the time left until the option contract expires. The time value is thus equal to the premium minus its intrinsic value.

There are a number of factors that affect options pricing, including volatility, which we'll look at below. The variables include the price of the underlying asset, the strike price, time to expiration, dividends (if any), and interest rates.

Implied Volatility

Volatility refers to the fluctuations in the market price of the underlying asset. It is a metric for the speed and amount of movement for underlying asset prices. Cognizance of volatility allows investors to better comprehend why option prices behave in certain ways.

Two types of volatility are most relevant for option prices. Implied volatility (IV) is a concept specific to options and is a prediction made by market participants of the degree to which underlying securities move in the future. Implied volatility is essentially the real-time estimation of an asset’s price as it trades. This provides the predicted volatility of an option’s underlying asset over the entire lifespan of the option, using formulas that measure option market expectations.

When options markets experience a downtrend, implied volatility generally increases. Conversely, market uptrends usually cause implied volatility to fall. Higher implied volatility indicates that greater option price movement is expected in the future.

Another form of volatility that affects options is historic volatility (HV), also known as statistical volatility. This measures the speed at which underlying asset prices change over a given time period. Historical volatility is often calculated annually, but because it constantly changes, it can also be calculated daily and for shorter time frames. It is important for investors to know the time period for which an option’s historical volatility is calculated. Generally, a higher historical volatility percentage translates to a higher option value. However, the long-run volatility of a particular security is thought to be mean-reverting, suggesting that there should be some fundamental average level of volatility based on its fundamentals. Therefore, if the observed volatility is quite high above this average level, it will tend to fall, and if it is far below, it should rise.

Option Skew

Another facet to pricing options using volatility is known as skew. The concept of volatility skew is somewhat complicated, but the essential idea behind it is that options with varied strike prices and expiration dates trade at different implied volatilities—the amount of volatility is not uniform across all options on the same underlying (even though the underlying itself can only have one volatility). Rather, higher implied volatilities are often associated with downside options; i.e. IVs are skewed to puts that can provide loss protection.

Every option, therefore, has an associated volatility risk, and volatility risk profiles can vary dramatically between options on the same underlying. Traders sometimes balance the risk of volatility by hedging one option with another.

The Bottom Line

Option pricing, also referred to as the premium, is the amount per share at which an option is traded. It's affected by a number of factors, including volatility. Volatility refers to the fluctuations in the market price of the underlying asset. Implied volatility is the real-time estimation of an asset’s price as it trades. It tends to increase when options markets experience a downtrend, and it falls when the options market experience an upward trend. Larger implied volatility means higher option prices.