InvestorQ : How to interpret Implied Volatility
Archita Jajjoo made post

How to interpret Implied Volatility

Answer
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Rashi Mehra answered.
2 years ago


The chart below captures how best to trade based on IVs at different levels of Implied Volatility and different types of market direction.

IMPLIED VOLATILITY

Low

Neutral

High

MARKET DIRECTION

Bearish

Buy Naked Puts

Sell the

Sell Naked Calls

Bear Vertical Spreads:

Underlying

Bear Vertical Spreads:

Buy ATM Call/Sell ITM Call

Buy OTM Call/Sell ATM Call

Buy ATM Put/Sell OTM Put

Buy OTM (ITM) Call (Put) Time Spreads

Sell OTM (ITM) Call (Put) Butterflies

Buy ITM (OTM) Call (Put) Butterflies

Buy ITM (OTM) Call (Put) Time Spreads

Sell OTM (ITM) Call (Put) Time Spreads

Neutral

Back spreads

Do Nothing

Ratio Vertical Spreads

Buy Straddles/Strangles

Sell Straddles/Strangles

Sell ATM Call Or Put Butterflies

Buy ATM Call Or Put Butterflies

Buy ATM Call Or Put Time Spreads

Sell ATM Call Or Put Time Spreads

Bullish

Buy Naked Calls

Buy the

Sell Naked Puts

Bull Vertical Spreads

Underlying

Bull Vertical Spreads

Buy ATM Call/Sell OTM Call

Buy ITM Call/Sell ATM Call

Buy ATM Put/Sell ITM Put

Buy OTM Put/Sell ATM Put

Sell ITM (OTM) Call (Put) Butterflies

Buy OTM (ITM) Call (Put) Butterflies

Buy OTM (ITM) Call (Put) Time Spreads

Sell ITM (OTM) Call (Put) Time Spreads

Based on the table above, let us see how we can use the concept of IVs in different market conditions.

Bearish market conditions: Typically bearish market conditions are signified by a consistent fall in the price of stocks including the index. In a bearish market if the IVs are low, then you buy naked puts. What are the advantages of this strategy? Firstly, buying a put is in tune with the overall bearish trend in the market. Secondly, when the IVs are low, you are not only betting on the option prices going up due to bearishness in the market but also due to an increase in the IVs which you are betting will mean reverse. What do you do when the IVs are neutral? Avoid the options and just sell the stock or look to selling the futures. When IVs are high in a bearish market scenario that is when you must be looking to sell naked calls. Here you are betting that the stock price will not go above a certain level. However, considering the high IVs it is not advisable to buy the put option. Instead, when you sell the naked call option, you can actually get the benefit of the market weakness and the volatility falling back to its mean reversion levels. There are also other hybrids that we can use in these conditions depending on your ability to understand the payoffs.

Bullish market conditions: Typically bullish market conditions are signified by a consistent rise in the price of stocks including the index. In a bullish market if the IVs are low, then you buy naked call options. What are the advantages of this strategy? Firstly, buying a call is in tune with the overall bullish trend in the market. Secondly, when the IVs are low, you are not only betting on the call option prices going up due to bullishness in the market but also due to an increase in the IVs which you are betting will mean reverse. What do you do when the IVs are neutral? Avoid the options and just buy the underlying stock or look to buying the futures. When IVs are high in a bullish market scenario that is when you must be looking to sell naked puts. Here you are betting that the stock price will not go below a certain level. However, considering the high IVs it is not advisable to buy the call option. Instead, when you sell the naked put option, you can actually get the benefit of the market strength and the volatility falling back to its mean reversion levels. There are also other hybrids that we can use in these conditions depending on your ability to understand the payoffs. Many of the hybrids may be slightly more complex in nature.