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These classes are all based on the book Trading and Pricing Financial Derivatives, available on Amazon at this link.

Hello youtube welcome back to my channel so today i’m just going to do a quick video on the topic of implied volatility now we’ve covered implied volatility already in this video series i did i did it at the end of my video on the black scholes model but i realized it sort of deserves its own standalone video because if someone is looking up by implied volatility

Maybe they don’t want to watch a whole video on black scholes let’s talk a little bit about implied volatility what it is and where we get it from so when we’re pricing an option there’s really just two things that go into the pricing of an option there is the price of the underlying that that were starting with and then there is the volatility of the underlying

Which is how much it moves around and there are a few other bits and pieces like love love interest rate and so on but the really important things are price of the underlying and the volatility of the underlying so therefore we can ask ourselves we know what we get the price of the underlying where do we get the volatility well there’s a few ways you can calculate

The volatility of something that which volatility is just a standard deviation right so we could take a price history of the underlying we’ll say if we look at a company like ibm right we could we could take ibm go online to yahoo finance or you know one of those places download the daily price data and calculate the standard deviation right and that would then tell

Us the the volatility of that stock now there’s a few little problems with that one of the problems is how much data should we use you know there’s some people and they would say well you know you should use as much data as is available right so we could then go and say oh okay well let’s take let’s take i’d know ibm has been around for 50 years let’s take 50 years

Of price data of ibm and we’ll we’ll see we’ll see what the volatility is and thus the swill will be able to price our options now that’s all well and good but other people would say well you know the problem is that ibm has changed a lot over that time you know there are a very different company today than they were many years ago so why would you possibly what

Why would you think that that old data is helpful and that’s a good argument as well so then those people might say well let’s just take i don’t know six months worth of data but that’s the most up to date that’s ibm as it is right now and we could do that and you know dazzle gives us a level of volatility and we can use that to price an option now all of these are

Great ideas as to how to you know come up with a reasonable number for standard deviation but the problem is that neither of those things are actually what we’re looking for because what matters what what will tell us that we perfectly priced our option is to have the volatility in the formula be equal to the volatility of that stock or of whatever that underlying

Is over the life of the option so if the option expires in three months we want to have the volatility be the level of volatility that will trade out over the next three months now how do we get that the problem with that idea is that that’s that is a volatility from the future we don’t know what will happen in the future so none of those things are what implied

Volatility is implied volatility instead is working backwards so instead of saying i need implied volatility to price an option instead we’re saying no no what we have is we have the formula for pricing options which is a black scholes binomial tree or you know whichever model you to use and then we actually have the price that those options are trading at in the

Market right now so instead of us trying to work out the price of the option when actually we know the price of the option it’s the option price in the market right now what we’re gonna do is we’re gonna take the price of the option we’re gonna work backwards through the formula and instead of solving for price we’re going to solve for volatility so we’re gonna say

That given that this option on ibm is trading at $1 right now that means that people expect the volatility of ibm over we’ll say the next three months to be 20% for example so implied volatility is volatility that’s backed out of either the black shorts at the binomial tree or really any any formula you want to use you basically work the formula backwards putting

In the price that’s observed in the market right now and solving for volatility and so that then is a forward-looking expectation of volatility now that doesn’t mean that that’s how volatile it will be right because we can’t predict the future all sorts of crazy things could happen in the future and it could be either way more volatile or way less volatile than

Implied volatility tells us to expect you know we can’t know you know what the future will hold but we are able to look at the price of an option and we’re able to say the market thinks that that this underlying will either be very calm or very volatile in the future we’re also able to compare options on one underlying two options on another underlying so we’re

Able to say well you know we’ve got two companies here coca-cola and pepsi and one of them is trading at a much higher implied volatility than the other now now we need to work out is there a good reason for that does it make sense is it to do with the capital structure of those companies is it something to do with you know one of the the products that they sell or

You know some upcoming announcement or something like that or is there a mispricing between the two so that’s what implied volatility is it’s a volatility that we’ve backed out of the the options price and it’s a forward-looking expectation of volatility rather than something calculated from historic data now that then leads us to things like indexes of volatility

So there’s things like the vix index and that is an index of implied volatility from s&p 500 options and so essentially the vix index is an index telling us what the prices of options are telling us how volatile option traders think that simpie will be over the next short period now i i won’t go too deeply into this but actually that’s even an interesting

Thing on its own because originally the vix was just an index that was sort of provided for informational purposes and then after that the vix became such a big thing that people wanted to trade futures on the vix options on the vix and then it almost has flipped such that people take vix futures and use those to price options you know so it’s all kind of a bit

Of a circular argument at this point but anyhow maybe i’ll save that discussion for a future video so so that’s it for today’s video i’ve sort of slowed down on doing weekend videos just because i’ve noticed that no one watches my videos on the weekend so i’m just doing monday to friday videos at the moment but this weekend i’m planning on putting off two videos

That are quite different to this type of video there’s there’s one on charles ponzi and when i’m bernie madoff simply because in in the class that i teach i cover bernie madoff in the class and i kind of look at you know what someone who’s knowledgeable about options is there is there a giveaway that bernie madoff was a fraud and so rather than rather than kind

Of dude the class like i’m doing right now what i’ve done is i’ve i’ve sort of created a slide show slash you know almost a documentary type thing that’s going a bit to cultivate documentary but i’ve created two videos that i’ll put up over the weekend hopefully you guys like them if you do tell me if you hate them let me know that too and i’ll stop and stuff

Like that up anyhow have a great weekend and talk to you later bye you

Transcribed from video

What is Implied Volatility? Options Trading Tutorial. By Patrick Boyle