Any volatility index will be weighted maximum for ‘At the Money’ options and by tracking these indices all we are tracking is the center point of the volatility moving up or down.
Derivative analysis has many tools to decode the market’s true forecasts but Implied Volatility has been one of the most important one. We are all familiar with India VIX as a barometer of volatility but is that all volatility analysis has to offer?
Any volatility index will be weighted maximum for ‘At the Money’ options and by tracking these indices all we are tracking is the center point of the volatility moving up or down.
But, what about the volatility for far options which is trying to speak some reality of the market? Let’s understand what implied volatility of ‘Out Of Money’ options has to offer to gauge the market.
The Concept:
Well, almost 98% moneyness put option on Nifty is quoting at 13.26 percent Implied Volatility whereas a 102 percent moneyness call option on Nifty is quoting at 10.62 percent Implied Volatility.
Now let’s ask ourselves, why would there be a difference in the Implied Volatility for equidistant options? And the answer is:
1. Option Seller of the Put option is looking for more compensation of premium than for Option Seller of a Call option
2. Supply of Put option is limited and buyers are more whereas the supply of call options are ample and buyers are less
These scenarios would occur if the market was expecting a higher probability of a correction than the probability of a rise.
These analysis are expiry specific and should be looked at expiries in isolation.
A modifier for Call Options:
In general, call options IV’s for up to a few strikes higher is lower due to the negative correlation of the market. If the market goes up, IV falls and for this reason, the curve remains flat at times but beyond a point starts surging again and this inflection point can be taken as a stiff resistance.
Reading the IV Curve:
The inference of market placements would come by tracking these levels of IV’s and comparing the change in them.
Bearish View:
If the put side is steep it means that the IV’s are higher for Out of the Money options and the market expects a negative movement to be more likely for that expiry. Due to the modifier stated above for call what needs to be tracked is the flattened area beyond which the market doesn’t expect the instrument to move for the expiry and again call option writers are looking for a higher compensation.
Bullish View:
A comparatively flattened curve or a less steep curve on the Put side would mean that the market is normal and a bull run is expected. The flattened area for the call option will be slightly longer in this case from At the Money which means that there is enough room for upside.
Sideways:
If the volatility curve is flat on both sides, it means that the market doesn’t expect any sharp move to happen and it’s a good month for Option writers in general to participate.
Volatile Market:
A volatile market where a sharp move is expected on either-side could be indicated by an equally steep IV curve on both sides. This means that options writers are scared on both sides of the market and looking for a higher compensation.
This might be of help to traders looking to make money from Option writing that these expiries are the ones to avoid as the risk is high and the yields are low unless one knows how to manage their risk properly.
