Volatility
What is volatility?
Volatility refers to the degree of fluctuation in the market price of the underlying asset and is an important dimension of options trading.
The higher the volatility, the greater the volatility of financial asset prices, and the greater the uncertainty of asset returns. The lower the volatility, the smoother the volatility of financial asset prices, and the stronger the certainty of the return on assets.
An increase in volatility would cause a higher premium because an increase in volatility will cause the exercise rate of any options contract on the expiry date to increase. For example, the current price of the underlying asset is 7000U, suppose you buy a call contract with an exercise price of 8000U. If the current volatility range rises from 10U to 500U, the probability of rising to 8000U before the exercise day will increase, and the exercise rate will increase, leading to an increase in the price of the premium. If the volatility range changes from 100U to 1U, then there is basically no chance to rise to 8000U before the exercise date, and the probability of exercise is very small, so this contract is worthless.
The manifestation of volatility
Volatility can be divided into historical volatility and implied volatility. For options investors, the focus is mainly on implied volatility, while historical volatility is usually used as a reference. The historical volatility is based on historical market data; the implied volatility is calculated backward based on the actual price and is usually used for the pricing of options contracts.
For example, July is the typhoon season in Shenzhen. For an office worker, Anna, whether to bring an umbrella or not has become the important question every time she went out. That day was July 15th, from the historical data of the past ten years, there is an 80% probability there will be heavy rains on that day. Anna decided to bring an umbrella to go out based on this data. However, when she ran to the window sill and looked down, and found that none of the residents in the community had an umbrella. Should she bring an umbrella on that day? When Historical data tells Anna to bring an umbrella today, but the other people in the community (implied volatility) do not bring an umbrella, so should Anna go out with an umbrella?
Implied Volatility (IV)
IV stands for Implied Volatility. It is a metric that captures the market’s view of the likelihood of changes in a given asset’s price. Implied volatility is often used to price options contracts: High implied volatility results in options with higher premiums and vice versa. Implied volatility does not predict the direction in which the price change will proceed. Low volatility means that the price likely won’t make broad, unpredictable changes.
Both historical volatility and implied volatility have the characteristics of mean reversion, which means that in the long run, whether it is higher or lower than the value center (or mean), it will return to the value center with a high probability. Therefore, the volatility will operate within a range and will not change drastically in the short term. In addition to long or short prices, options traders can also create income through long or short volatility, regardless of whether the price rises or falls, they can obtain additional income. Therefore, options provide investors with more profit options.
VIX
The Cboe Volatility Index, or VIX, is a real-time market index representing the market’s expectations for volatility over the coming 30 days. Investors use the VIX to measure the level of risk, fear, or stress in the market when making investment decisions. It is derived from the price input of S&P 500 index options and is compiled based on the implied volatility of the options. In options trading, the implied volatility usually represents the expected degree of market risk in the future, so VIX is often regarded as a vane leading the market. A high VIX market often means the spread of panic. The fear and greed index we see on many analysis platforms is derived from VIX.
Volatility Smile
Volatility smiles are implied volatility patterns that arise in pricing financial options. It refers to the implied volatility of the options on the graph with the strike price as the abscissa, showing a U-shaped image with high at both ends and low in the middle. In theory, for options with the same expiration date, we expect the implied volatility to be the same, no matter which strike price we use. However, in reality, the IV we get is different across the various strikes. This disparity is known as the volatility skew. If you plot the IV against the strike prices, you might get the following U-shaped curve resembling a smile. Hence, this particular volatility skew pattern is better known as the volatility smile.
Volatility Surface
The volatility surface is a three-dimensional plot of the implied volatility of options, where the x-axis is the time to maturity, the z-axis is the strike price, and the y-axis is the implied volatility. An example of BTC Volatility Surface is shown below.
Vega
Premium Change = Volatility * Vega
Vega is the measurement of an options’ price sensitivity to changes in the volatility of the underlying asset. Vega represents the amount that an options contract’s price changes in reaction to a 1% change in the implied volatility of the underlying asset. Vega does not have any effect on the intrinsic value of options; it only affects the “time value” of an options’ price. As the exercise date approaches, the value of Vega gets smaller and smaller. For example, if your contract expires in one second, the Vega value will be infinitely close to 0. At this time, even if your volatility is very large, this will not have a great impact on your premium.
