Algorithmic Trading: Trade Professionally With Implied Volatility

motek 1The implied volatility article was written by Chloe Peng, Analyst at I Know First. Master of Science of Finance candidate at Brandeis University.

Summary

  • Implied volatility reflects the forecasted likelihood of certain price movements and thus can be used to evaluate option prices.
  • Buy when options are traded at lower implied volatility and sell when they are traded at higher implied volatility.
  • I know first’s volatility forecast package helps professional option traders to better decide on their positions.

When people discuss the financial market, the common question would be: “what’s your position?” The answer is very likely to vary based on the person’s level of expertise. For beginners, the answer is normally, “I own XXX and YYY stocks.” And for intermediate traders, it would be “I have a covered call and other option positions to hedge risks.” But for professional traders, the answer could involve being “long or short volatility”. In this article, I will present you why professional investors trade on volatility and how I Know First’s AI solutions can help.

(Source: Catana Capital)

What Is Implied Volatility?

Volatility is a measurement of how much a company’s stock price rises and falls over time. When we look at the stock charts and historical data, it’s easy to calculate volatility with the mathematical formula. this volatility we calculated is already realized during the time, and is already observed by the market.

However, implied volatility (also IV further) is the market’s forecast of a likely price movement and is measured as a percentage and is forecasted annually. It is calculated over a normal distribution graph or bell graph. Backed the mathematical theories, IV shows the degree of the price change over 1 standard deviation, which usually equals 68%. For example, a $50 stock with a 20% IV has a 68% chance to be priced between $40 and $60 one year later. See chart below.

IV future-oriented, thus can be used to project future changes in the price and evaluate prices on stock options. It is directly influenced by the supply and demand of the underlying options and by the market’s expectation of the share price’s direction. Higher implied volatility implies that the market is expecting a stronger movement and vice versa. It is the most important influencers of option pricing and is positively correlated with option premium. When an option has a higher IV, we need to pay more for the option.

How To Trade On Volatility?

Investors typically own stocks and tend to have an upward bias toward the stock market, whatever the size of their positions or portfolios. Professional traders, on the other hand, seek to generate profits in both directions—up and down. They look for opportunities where events have caused things to be temporarily “out of whack”, meaning that stock options can be a good investment. In this section, I will explain how you can be advantaged with implied volatility to when trading options.

The first step, of course, is to determine whether IV is high or low and whether it’s falling or rising. Because when it increases, option premiums become more expensive. And when it decreases, options become less expensive. And when it reaches extreme highs or lows, IV is likely to revert to its mean.

Second, you may want to know what event caused high implied volatilities or is it caused by seasonal factors. It could be rumors on product approval that may boost market expectation and confidence. The demand to participate in such events drives option prices higher. Or it’s just seasonal changes. You see from the following chart that spring and summer historically drag down volatility unless events drive it higher.

Moreover, implied volatility is mean reverting, meaning that it will come back to normal after extreme times. When the anticipated events actually occurred, IV will collapse and revert to mean. There are periods of extreme S&P500 IV. For example, August 2015 and early 2016. And then, the ebb and flow of IV returns to long-term average.

(Source: Ameritrade)

Third, buy low and sell high. Options are cheap when IV is low and vice versa. Investors can buy options when IV is low and wait until an extreme point to sell the options. For instance, you see from the above picture, it is suitable to buy options in July 2015 if you anticipated the significant increase in volatility. The extremely high volatility in August caused options to increase in value and you would earn a lot if you sell the options in August.

Besides, when high volatility is expected, you can use straddle strategy, which is structured by buying one call and one put, to help you take advantage of increased volatility in any price direction. It is straightforward that investors would buy low and sell high to earn profits. The question would be: how to get the precise forecast on implied volatility?

Free Yourself From The Complex Volatility Estimation

Professional traders will be in favor of option trading for many reasons. For example, option premium is normally much cheaper than the underlying stock price, so that investors can lever up. By buying options instead of the underlying stock represented in the option contracts, a trader can theoretically generate the same amount of profit over time with a much smaller up-front investment.

As I presented in the above section, it’s necessary to measure implied volatility in order to find opportunities. Investors don’t need to be an expert on every mathematical detail of implied volatility measurement and can know free themselves from complex data analysis. I Know First provides its customers with algorithmic trading forecasts on volatility for investors and analysts who need predictions of the implied volatility for a basket of put and call options related to a specific index. The forecast package will be presented in a heat map with recommendations for both long and short positions. See chart below.

Highest implied volatility forecast example

The above chart is used to deliver our daily forecast to clients. Each forecast include 2 indicators: signal and predictability. The signal represents the predicted implied volatility movement and it indicates how much the IV is likely to change. In this case, a high positive signal shows that we expect the IV to increase significantly and a high negative signal shows that we expect the IV to decrease significantly. Low signals on both sides means we expect IV to fluctuate slightly compared to the date of forecast.

Predictability is the historical correlation between the past algorithmic predictions and the actual volatility value movement for each particular asset. Thus, the higher the predictability is, the more accurate the AI was forecasting the asset.

How The Predictive AI Works?

I Know First’s well-trained trading algorithm is based on artificial intelligence and machine learning with Artificial Neural Networks and Genetic Algorithms incorporated in. This means that the algorithm is able to create, modify, and delete relationships between financial assets and generate forecast using the relationships and historical data. Moreover, the algorithm is able to learn from its previous forecasts and adapt to the relationships, it can quickly adjust to changing market situations.

Our AI algorithm is smart enough to produce accurate predictions. In fact, I Know First is now providing daily forecasts for more 10,500 assets with six investment horizons. We have successfully monitored and forecasted on volatility for more than 15 years, during which time the AI learned from past results and improved itself.

Recently, I Know First started to produce a new kind of stock market forecast – predictions for options for stocks with high implied volatility. We invite all the interested investors to check out these new stock market predictions on our website.

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Please note-for trading decisions use the most recent forecast.