Expected Implied Volatility
Although there is a great deal of science that can be applied to calculating
expected actual volatility, developing expectations for implied volatility is
more of an art. This element of an option’s price provides more risk and
more opportunity. There are many traders who make their living distilling
direction out of their positions and trading implied volatility. To be
successful, a trader must forecast IV.
Conceptually, trading IV is much like trading anything else. A trader who
thinks a stock is going to rise will buy the stock. A trader who thinks IV is
going to rise will buy options. Directional stock traders, however, have
many more analysis tools available to them than do vol traders. Stock
traders have both technical analysis (TA) and fundamental analysis at their
disposal.
Technical Analysis
There are scores, perhaps hundreds, of technical tools for analyzing stocks,
but there are not many that are available for analyzing IV. Technical
analysis is the study of market data, such as past prices or volume, which is
manipulated in such a way that it better illustrates market activity. TA
studies are usually represented graphically on a chart.
Developing TA tools for IV is more of a challenge than it is for stocks.
One reason is that there is simply a lot more data to manage—for each
stock, there may be hundreds of options listed on it. The only practical way
of analyzing options from a TA standpoint is to use implied volatility. IV is
more useful than raw historical option prices themselves. Information for
both IV and HV is available in the form of volatility charts, or vol charts.
(Vol charts are discussed in detail in Chapter 14.) Volatility charts are
essential for analyzing options because they give more complete
information.
To get a clear picture of what is going on with the price of an option (the
goal of technical analysis for any asset), just observing the option price does
not supply enough information for a trader to work with. It’s incomplete.
For example, if a call rises in value, why did it rise? What greek contributed