Shubham Agarwal: Implied Volatility Hints at Underlying Market Trends

Understanding Volatility and Its Role in Equity Trading

Volatility is the key driver behind equity trading. Without volatility, there would be no returns for traders because the value of assets would remain unchanged. As a result, volatility becomes not just a measure of price movement but an essential element that determines the profitability of trading in equities, especially in equity options.

Before delving into Implied Volatility (IV), it is important to first understand the factors that contribute to the calculation of an option premium. The option premium, essentially the price of an option, is influenced by several variables, including:

1. Stock Price

2. Strike Price

3. Time to Expiry

4. Interest Rate

5. Dividend Yield

6. Volatility

Among these six factors, the first five—stock price, strike price, time to expiry, interest rate, and dividend yield—are already known or can be calculated directly. However, volatility remains the elusive factor, which is not directly observable and needs to be inferred from the market itself. This is where Implied Volatility (IV) comes into play.

Highlights:

• Volatility is a crucial factor in equity trading as it drives potential returns.

• Six key factors contribute to the calculation of option premiums, with volatility being the unknown factor.

• Implied Volatility is derived by back-calculating from the market price of the option premium.

What is Implied Volatility (IV)?

Implied Volatility is essentially the expected volatility of an underlying asset during the life of an option. It is called “implied” because it is not directly observable but is inferred from the market price of options. In simpler terms, it is the market’s expectation of how volatile the underlying asset or index will be in the future, as implied by current option prices.

To calculate IV, all other factors in the option pricing model—such as stock price, strike price, time to expiry, and interest rate—are already known. The only variable left is the volatility, which can be solved by using the market price of the option premium. This allows traders to anticipate the future volatility of a stock or index based on current option prices.

Highlights:

• Implied Volatility represents the market’s expectation of future volatility for an underlying asset.

• IV is derived by back-calculating from the market value of an option premium.

• It serves as a forward-looking indicator, guiding traders about potential future volatility.

Characteristics of Implied Volatility

Now that we understand the basic concept of Implied Volatility, let’s explore its three main characteristics that help reveal the underlying trends of the equity market:

1. Implied Volatility is Expected Volatility: IV provides an estimate of how volatile an asset is expected to be over the life of the option. It is a forward-looking measure, indicating the market’s expectations rather than historical volatility.

2. IV is Range-Bound: Like volatility, IV operates within a certain range. While volatility can lead to significant price movements in either direction, IV itself is constrained within a range. Think of IV as the “momentum” behind price movements, with speed (IV) typically ranging between 0-200 km/h, no matter how far the distance (price movement) can extend.

3. IV and Price Movements are Inversely Related: An important characteristic of IV is that rising IV is generally associated with a falling market, while falling IV tends to coincide with a rise in the market. This inverse relationship between IV and the price movement of an asset can be a powerful tool for traders looking to predict market reversals and trends.

Highlights:

• Implied Volatility represents expected future volatility rather than past price movements.

• IV operates within a defined range, similar to momentum in motion.

• There is a negative correlation between rising IV and market movements, with IV increases often signaling a fall in the underlying asset.

IV and Nifty: A Case Study

To demonstrate the power of Implied Volatility in revealing underlying trends, let’s consider an example using NIFTY IV and Nifty Future charts. By combining the second and third characteristics of IV, we can make certain observations:

• Inverse Relationship: As seen in the charts, the moves in the IV chart and the Nifty Future chart tend to be opposite. Specifically, when IV makes a high, the Nifty Future tends to make a short-term low, and vice versa. For instance, in early April, when the IV chart showed a spike, Nifty Future marked a short-term low. This negative correlation is a typical feature of the relationship between IV and underlying asset prices.

• Trend Secrets: The negative relationship between IV and market prices can help traders identify trends and potential reversals. For example, a recent peak in IV can signal an impending reversal, even if the direction of the market is uncertain. Monitoring IV can provide valuable clues about potential price movements before they occur.

Highlights:

• The relationship between NIFTY IV and Nifty Future highlights the inverse correlation between implied volatility and market direction.

• Observing IV peaks and troughs can offer insights into potential trend reversals.

• An increase in IV may signal a potential market fall, while a decrease could indicate a rise.

Practical Applications of IV: Trend and Reversals

Implied Volatility plays a crucial role in identifying both trend directions and reversals in the market. Traders can use the following insights:

1. Trend Confirmation: For stocks that are consolidating, falling IV typically indicates that volatility expectations are low, which suggests that the stock is unlikely to fall further after consolidation. On the other hand, rising IV in consolidating stocks signals an increased expectation of price movement, either upward or downward.

2. Reversal Signals: As mentioned earlier, a recent peak in IV, particularly during a downtrend, can signal that the market is due for a reversal. A sudden spike in IV often precedes sharp market movements, making it a reliable indicator for traders looking to position themselves ahead of price swings.

Highlights:

• Falling IV in consolidating stocks indicates lower volatility expectations and potential trend stability.

• Rising IV during consolidation signals increased volatility and potential price movement.

• A peak in IV can serve as a reversal signal, alerting traders to impending changes in market direction.