Understanding Implied Volatility and How It Can Be Used As a Sentimental Indicator | OptionsANIMAL
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Understanding Implied Volatility and How It Can Be Used As a Sentimental Indicator

Implied Volatility can be simply thought of as the “expensiveness” of options. There’s a bunch of math – but let’s keep this simple.

I often use the analogy of insurance, which is actually more than an analogy; insurance is technically a put option.

Let’s use homeowners insurance as an example. What does it cost to insure a water-front, single-family, detached home worth $1,000,000? To answer the question, you need more than the price of the home. What is the term – 1 month, 6 months, a year? What is the deductible – $2,000, $500, $0?

Let’s say it’s for 1 month and $0 deductible. What should the insurance cost?

You would still need more information to determine the price. You need to know something about the location to determine the risks.

Let’s say one home is on Lake Champlain in Burlington VT and the other is oceanfront in Miami, FL. All other things being equal who’s insurance would be more expensive?

Burlington has some of the lowest crime and natural disaster occurrences in the nation. Miami, well not so much. It’s probably intuitive that Miami would cost more money even though the home prices and other terms are the same.

Now, let’s say that it’s mid-September and there’s a class 5 hurricane heading straight for Miami. Would you expect the price of the insurance to change? Foregoing any laws about insurance prices and assuming it operates as a free market, you would expect that the price would be even higher with a hurricane bearing down on Miami.

The day before Miami is about to get clobbered by the hurricane, and it veers North and heads for Cape Hatteras. Miami disaster averted, and the price of home-owners insurance drops down to the normal price.

The variable that causes the price of the insurance to become more expensive is the implied volatility (IV), which is a measure of risk.

For traders, the risk is of movement of the stock – not just of a bearish move. In our markets, hurricanes (e.g., earnings events) can destroy the stock or pour gold on it and make it worth more.

When options traders expect there to be future movement of the stock, they buy options. They may be bullish or bearish or both, but they still buy options. And what does that do to the price of options? Go back to Economics 101 – Supply and Demand. The prices go up when demand goes up.

This is where Implied Volatility comes from – the market demand.

This is all pretty straightforward. The question that I am often asked is: how do you use Implied Volatility as a sentimental indicator?

This takes some second-level thinking.

Let’s go back to the insurance analogy.

Suppose we could track the price of insurance for a home in Miami. If we watch the price of insurance through the year (remember it’s a free market.) You would probably see a rise and fall throughout the year. When would insurance prices be the highest? The peak of hurricane season.

Imagine that insurance prices look like this.

Even if you knew nothing about Miami, you would conclude that risk increases in the Summer and early Fall. And with a little more research, you’d find that the monthly price of insurance correlates with the probability of a hurricane.

Historically, September has the highest number of hurricanes. That is why it’s the most expensive month.

Now, let’s imagine that you are monitoring the current prices for insurance in Miami for July and you see the following.

The price of insurance for July more than doubles.

What would cause this? What would you do? You’d probably go to the Weather Channel to see what’s up with hurricane forecasts in the Atlantic.

But don’t you already know that it’s because there’s a forecast for a hurricane hitting Miami?

In this manner, we can almost forecast the weather by looking at the prices of insurance. Crude, but there’s a correlation. Of course, for Miami, it could be some other risk. Maybe there’s flooding, fires, giant meteor, or a zombie outbreak. But you know for sure that the risk has increased.

We use the Implied Volatility Index in much the same way. We can monitor to see what normal prices are for options. When we see those prices rise and fall, we know that it has to do with the market’s perception of risk.

Take this current example below from iVolatility.com for FL. (That’s FootLocker, not Florida!)

What can you conclude about where the gold line is now? It’s about 60%. Why? Because there’s a hurricane coming – earnings. Is this a “normal” hurricane forecast? Yes. Probably.

It might get a little higher – because that’s what it has done for the past four earnings events. But we wouldn’t expect it to be at 80%.

What would you do if it went to 80%? You’d go check the weather forecast for FL because it looks like a big hurricane is coming and it’s going to really move the stock. Remember, earnings hurricanes can be either good or bad.

What do you expect to happen with the gold line in about a month? Would you expect it to be high or low? It should drop, like a rock to about 35%, right after earnings.

Now, let’s say that it’s the middle of September and you see the IV Index shoot up to 50%. What should a trader do? Place a trade? I am guessing that wouldn’t be your first move – unless you were putting your current trade in a protective position or closing it to take profits.

Batten down the hatches! Is probably the prudent response. You need to go do some research. Check the news. Check Twitter. Find an experienced trader in FL like we have here at OptionsANIMAL and ask them.

I have seen the very thing happen with AAPL several years ago. Back in 2012, I was teaching a Practical Application Workshop, where we were going through the OptionsANIMAL 6-Step process for setting up a trade. When it came to doing our Sentimental Analysis, I pulled up an IV Index chart, and there was a big spike in the gold line. I have traded AAPL for years. I know that IV rises with earnings, product announcements, and the overall market. But none of those were on the horizon. I told the class that we couldn’t place a trade because someone knew something. In fact, many people knew something. But it wasn’t us. That weekend Apple surprised the market by announcing a dividend. Some traders had an inkling that something big was happening and that’s what drove the IV Index higher.

In hindsight, it went bullish, and I would have liked to have done a bullish trade because that was what my Technical Analysis and Fundamental Analysis were telling me. But you couldn’t tell from that rise in the IV Index whether the stock was going to be bullish or bearish.

Here’s the cool thing that experienced and educated options traders also understand, these rises and falls in implied volatility can be traded. That’s an advanced topic that requires a broader foundation of knowledge in options. But if the trader doesn’t want to play these changes in IV, as a Sentimental Indicator, the IV Index can help them get an idea of if a hurricane is coming and how bad the market expects it to be.

This is how we can use Implied Volatility as a Sentimental Indicator

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Eric Hale

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