How can you measure implied volatility and option premiums?

1 Implied volatility indicators

One way to measure implied volatility is to use indicators that plot it on a chart, such as the Volatility Index (VIX), which tracks the implied volatility of S&P 500 index options, or the Implied Volatility Rank (IVR), which compares the current implied volatility of an option to its historical range. These indicators can help you identify periods of high or low volatility, which can affect the option premiums and the strategies you choose. For example, when implied volatility is high, option premiums tend to be higher, which can make selling options more attractive than buying them.

2 Option pricing models

Another way to measure implied volatility and option premiums is to use option pricing models, such as the Black-Scholes model, which calculate the theoretical value of an option based on various inputs, such as the current price, strike price, expiration date, interest rate, dividend yield, and implied volatility. By using an option pricing model, you can estimate the implied volatility of an option by plugging in the other inputs and the observed option premium, and then solving for the implied volatility variable. Alternatively, you can estimate the option premium by plugging in the other inputs and the implied volatility you expect, and then solving for the option premium variable.

3 Historical volatility and standard deviation

A third way to measure implied volatility and option premiums is to compare them to the historical volatility and standard deviation of the underlying asset. Historical volatility is a measure of how much the price of an asset has moved in the past, based on a certain time period and frequency, such as daily or weekly returns. Standard deviation is a measure of how much the price of an asset deviates from its mean or average, based on the same time period and frequency. By comparing the implied volatility and option premiums to the historical volatility and standard deviation, you can assess whether the options are overpriced or underpriced, relative to the historical performance of the asset.

4 Delta and gamma

A fourth way to measure implied volatility and option premiums is to use the option greeks, which are derivatives of the option pricing model that show how the option premium changes with respect to various factors, such as the price, time, and volatility of the underlying asset. Two important greeks are delta and gamma, which measure the sensitivity of the option premium to the price and the rate of change of the price of the underlying asset, respectively. Delta ranges from 0 to 1 for call options and -1 to 0 for put options, and indicates how much the option premium changes for every $1 change in the price of the underlying asset. Gamma ranges from 0 to infinity, and indicates how much the delta changes for every $1 change in the price of the underlying asset. By using delta and gamma, you can estimate how much the option premium will change with respect to the price movements and the implied volatility of the underlying asset.

5 Vega and theta

A fifth way to measure implied volatility and option premiums is to use two more option greeks, which are vega and theta, which measure the sensitivity of the option premium to the volatility and the time of the underlying asset, respectively. Vega ranges from 0 to infinity, and indicates how much the option premium changes for every 1% change in the implied volatility of the underlying asset. Theta ranges from -infinity to 0, and indicates how much the option premium decreases for every day that passes until the expiration date. By using vega and theta, you can estimate how much the option premium will change with respect to the changes in the implied volatility and the time decay of the underlying asset.

6 Implied volatility skew and smile

A sixth way to measure implied volatility and option premiums is to use the implied volatility skew and smile, which are graphical representations of how the implied volatility varies across different strike prices and expiration dates for the same underlying asset. The implied volatility skew shows how the implied volatility is higher for out-of-the-money options than for at-the-money or in-the-money options, which reflects the higher demand and risk for those options. The implied volatility smile shows how the implied volatility is higher for both deep out-of-the-money and deep in-the-money options than for at-the-money options, which reflects the higher uncertainty and leverage for those options. By using the implied volatility skew and smile, you can compare the implied volatility and option premiums across different strike prices and expiration dates, and identify potential arbitrage or hedging opportunities.

7 Here’s what else to consider

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