Implied volatility is determined from the option price, given an underlying’s spot price, the option’s strike price, the risk-free rate, and the time to expiry of the option. Previously in this column, we discussed how to interpret implied volatility. This week, we look at how implied volatility changes and why the change in implied volatility for calls ought to affect the implied volatility for puts.

Demand factor

The demand for a strike can change its implied volatility. If you were to hold the spot price, strike price, the risk-free rate and time to expiry constant, an increase in demand for a strike will lead to increase in its option price. An increase in the option price will lead to an increase in the option’s implied volatility. Likewise, a decrease in demand for a strike will lead to decrease in the option price, translating into a decrease in its implied volatility. Note that implied volatility is part of the time value of an option. We know that the time value of an option will become zero at expiry. So, you want to pay less for time value when you buy options. That means you must buy a tradable strike with low implied volatility relative to other tradable strikes.

There is another interesting factor about implied volatility. When implied volatility for a call option increases, the implied volatility for the same strike put option ought to go up too. Why? The put-call parity argument is that a combination of a call option and a bond whose maturity value is same as the strike price should be equal in value to the underlying price and a put option of the same strike as the call. So, when call price increases, put price ought to go up too. Otherwise, an arbitrage opportunity exists. This argument is conceptual. When an underlying is beginning an uptrend, it is more likely that the call prices will increase with an increase in its implied volatility. It is also not uncommon to see a decrease in demand for puts, translating into a lower implied volatility compared with calls.

This leads to two observations. One, it is not meaningful to interpret implied volatility as the market’s expectation of the underlying’s volatility during the remaining life of the option; for a sharp change in demand will affect the option’s implied volatility. And two, implied volatility must be used as a relative metric at best, as you want to pay less for time value.

Take note
The implied volatility of an ATM call and put could give you an indicator of the market sentiment — higher call volatility could mean that market has a small upside bias on the underlying
Optional reading

Implied volatility could be meaningful when you expect the underlying to move in a tight range. The implied volatility of an at-the-money call and put could give you an indicator of the market sentiment — higher call volatility could mean that market has a small upside bias on the underlying. If your view is in line with this bias, you may want to short the put, even though the call has a higher implied volatility.

The author offers training programmes for individuals to manage their personal investments

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