In Options trading, traders are often exposed to a concept called volatility. In particular, they encounter implied volatility (IV), a term you can see on Bybit's Options Trading page. This article provides a comprehensive introduction to IV so that you can better understand the future volatility of the underlying price and use IV to trade Options.

IV is critical to Option pricing, and can be considered as another way of pricing an Options contract. In Options trading, the prediction of IV will directly affect your profit and loss.

 

 

Basic Concepts: HV and IV

Historical volatility (HV) of an underlying asset can be used to analyze its volatility over a period of time.

Implied volatility can predict possible movements in the price of an underlying asset. IV indicates how traders in the Options market perceive the volatility of the underlying asset.

Please note that both HV and IV are presented to traders at an annualized rate.
 

 

 

How IV Affects Option Prices

Options prices, known as premiums, are composed of the sum of in-the-money (intrinsic) and out-of-the-money (time value). The in-the-money (ITM) part is equal to the Option exercise value, which is only related to the underlying asset price and the Option strike price, and is not affected by the Option Greeks.

Therefore, the effect of IV on the Option price is on the out-of-the-money (OTM) position of the Option.

The impact of IV on Option prices can be measured using vega, which indicates how much an Option’s price will change for every 1% change in the IV of the underlying asset. 

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Option Greeks

All other factors equal, the higher the IV of an Option, the greater the possibility of the underlying asset's future volatility — and the higher the Option price will be.

Example

Suppose Trader A holds the following BTC Call Option:

• Current BTC price: 20,000 USDT
• Strike price: 25,000 USDT

The greater the fluctuation of the underlying price, the better, so that the probability of the underlying price breaking past 25,000 USDT is higher.

If the price of the underlying asset rises but the market price fluctuates less, it’s possible that when the Option expires, BTC’s price rise won’t exceed 25,000 USDT. In this case, the call Option held by Trader A won’t be profitable, and the premium will be lost.

As an Options’ buyer, you want to see the price of the underlying asset fluctuate as much as possible. Conversely, if you’re an Options seller, you would want the underlying assets price to be less volatile.

Therefore, the greater the fluctuation of the underlying price, the higher the IV of the Option — which means that the market generally predicts the higher probability of the Option being profitable, and the Option price being higher.

 

 

 

IV and Expiration Time

The effect of IV on an Options’ price is different for Options with different expiration times.

The further the Option is from expiration, the greater the effect of IV on the Option price. 

The closer the Option is to its expiration date, the less uncertainty there will be in the price movement of the underlying asset as it will be less affected by volatility. Therefore, Options are priced with less uncertainty.

 

 

 

IV and Strike Price 

In general, the IV is lowest when the strike price is equal to the price of the underlying asset. The greater the difference between the strike price and the underlying asset price, the higher the IV, which forms an arc-shaped curve, known as a “volatility smile.”

 

There are two main reasons for the formation of the volatility smile:

1. The volatility of the underlying asset corresponding to different strike prices varies. For Option buyers, the further the Option’s strike price deviates from the current market price, the higher the probability that the underlying asset price can reach the strike price.

2. From a hedging perspective, an OTM Option may become ITM because the underlying asset price may suddenly rise sharply. In this case, it’s difficult for Option sellers to hedge their risk. To compensate for this risk, the higher the OTM Option, the higher the IV for that Option.

This also means that Options that are closer to expiration will have a more pronounced volatility smile than Options that are further from expiration. Options that are very far from expiration tend to have flatter volatility smiles.

Another interpretation for the volatility smile comes from the Black-Scholes model, used in Option pricing, which assumes that the volatility of the underlying asset price follows a normal distribution. However, the actual situation is often not ideal. The probability of the underlying asset price hitting the strike price is often higher than the theoretical value calculated by the model, so the IV will also be higher.

However, the IV of an Option, like the price of an Option, is traded between buyers and sellers in the Option market. The market's expectations of the underlying price and volatility, as well as the trading volume and position of an Option, all have an impact on IV. 

Therefore, we also see cases where the volatility curve doesn’t form a standard arc, or the IV lowest point deviates from the ATM part, etc.

 

 

 

Assessment of IV level 

If IV represents the predicted possible change in the price of the underlying asset, then there will be overvaluation and undervaluation. In general, when IV > HV, IV is high, and when IV < HV, IV is low.

The specific analysis process is as follows:

Generally, we use prices from a past period of time, such as 20 or 60 days, to calculate historical volatility. 

The following situation may occur: In the event of sudden and large market price movements, HV underestimates the current actual volatility (due to the average of past data), and is significantly lower than IV.

In this case, we can use intraday and more frequent (or shorter) time period data to measure the latest historical volatility, which may lead to an overestimation of future market volatility. However, it provides a more realistic reflection of delta hedging cost for short Options.

Therefore, when we see that an Option's ATM IV is higher than its long-period historical volatility and higher than its short-period historical volatility, it means that the Option's IV is likely to be overvalued. In this case, we can consider choosing some Option strategies for short vega, such as the short straddle. 

Correspondingly, if an Option’s IV is much lower than its long-period historical volatility and also lower than its short-period historical volatility, it means that the IV of the Option may have been underestimated. We can consider choosing some long vega strategies, such as the long straddle.

Here are some Options trading strategies for your reference:

 

 

 

 

How to Trade Options With IV

You only need to select IV Mode on the Option order page to place your order directly according to the IV. For more information, please refer to How to Get Started with Options Trading on Bybit.

 

Please note that placing an order based on IV — that is, your order price — will change with the price of the underlying asset and the expiration time of the Option.

 

 

 

Conclusion

The IV is an important indicator for traders to assess whether an Options price is reasonable. If you think that the future price volatility of the underlying asset is much lower than the expected IV, you can consider shorting the IV and vice versa.

When trading IV, there are some common volatility trading strategies (mentioned above) you can consider. Alternatively, you can also consider dynamically hedging your delta while trading IV to keep your position “delta neutral” at all times. This requires you to have trading software that satisfies this function, in addition to continually monitoring the change of your delta value.