Whenever equity market participants, be it traders, brokers, investors or dealers, meet each other, one can hear a common question that starts a conversation – “Where do you think the market is headed?”
Experts use several technical calculations, advanced data science and methodologies to try and predict the direction of the markets. One such interesting tool, adopted all over the world, is analysing the options market data to provide inputs on the price movements of underlying security, and using those inputs to further predict market direction is study of implied volatility.
Traders also use the implied volatility of the options market to help determine market movements. Volatility, by definition, is a measure of how much the price of a stock can swing in either direction. Implied volatility shows the market’s opinion of the stock’s potential moves, but not the direction that it is going to move in. High implied volatility is an indicator for potentially large swings and vice versa. Implied volatility is calculated using various options pricing formulas, like Black Scholes formula, time value for options pricing, and comparing that with the current market price of the option.
If the current market price is higher than the price calculated using the formula, it can be said that the implied volatility is high. Options with high implied volatility are usually sold to benefit from the decline in volatility expected in the future. The reverse is true for options with low implied volatility.
More often than not, the implied volatility of individual stocks tends to rise ahead of major developments, news or announcements in the company and traders sell to benefit from the decline in expected volatility in the future.
Even though theoretically implied volatility is not useful for signalling market direction, traders generally tend to read high implied volatility as a sign of bearishness. Since it is generally believed that markets tend to fall faster than they tend to rise, traders rush to protect their investments as soon as implied volatility rises over a certain limit.