The last lesson introduced historical volatility, which allows investors to analyze the fluctuations of a stock price in the past. This lesson will focus on implied volatility, which represents the market's future expectation of fluctuations in the stock price. As noted before, because implied volatility is an estimation of future volatility, it will change often and can be inaccurate.at times. However, because implied volatility is an input into the option pricing model, it is important to understand.
When investors analyze implied volatility levels, they are assessing the expected risk of the stock. The following examples again represent one stock with low implied volatility and another stock with high implied volatility:
The chart below shows the 30-day implied volatility of GLD. The current implied volatility level is 25%. This means that investors are expecting the stock price of GLD to fluctuate 25% over a year's time (252 trading days). Therefore, if GLD is trading for $100 per share, investors are expecting the stock price to fluctuate between $75 and $125 over the next year based on the current implied volatility levels.
Another important aspect we can take away from the chart above is that implied volatility has decreased steadily over the last year. This typically represents that the underlying stock price has risen consistently. The chart below illustrates this example.The trendlines have been drawn in to show the divergence that is taking place: as the underlying stock has risen over the last year, implied volatility has fallen:
Implied volatility is forward-looking and therefore not static (it is constantly changing). Certain events can cause implied volatility to rise rapidly (earnings announcements, accounting scandals, etc.) when expectations become uncertain. Also, implied volatility can decrease as investors become more certain of price fluctuations (an option contracts expiration date approaches, underlying stock price rises, etc.).
Many stocks typically become more volatile before earnings announcements, hence implied volatility rises leading up to the event. For example, Research In Motion (RIMM) is a perfect example:
The
chart above tracks the volatility levels of RIMM. The 30-day
implied volatility (red) and 30-day historical volatility (light blue)
levels are tracked. The underlying stock price is not shown. The
balloons with the letter “E’
inside of them represent earnings announcements by the company. We have
drawn
in the blue lines to show how as each announcement approaches, implied
volatility (red) begins to rise because investors become uncertain how
the stock will react to the announcement. In most cases, the implied
volatility decreases after
earnings because the uncertain move in the stock occurs and investors
once again become more certain of future prices.
All stocks react differently to earnings announcements and other
uncertain events. In
this case, implied volatility rises before RIMM's earnings announcements
with good reason.
The last four announcements by RIMM have led to next-day
moves in the stock of -17%, -6%, +24% and +12%, respectively.
By understanding where current levels of implied volatility are in comparison to past levels, investors can make informed decisions on how implied volatility is affecting option premiums on the underlying stock.
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