What is implied volatility: how IV impacts crypto option premiums

Did you know that you can still lose money when trading crypto options despite prices moving in your favor? That's due to the impact of implied volatility (IV) on option premiums. With highs and lows that you usually see on roller coasters, the implied volatility of Bitcoin and Ether options can be tricky to navigate for anyone new to crypto options trading.

Keen to establish strong foundations in crypto options trading? Our guide to implied volatility and its impact on crypto option premiums will be perfect for you as we explain what is implied volatility and expand on option trading strategies that make use of this key metric.

TL;DR

• Implied volatility is a metric that reflects the market's expected volatility of asset prices.

• IV is typically calculated using the Black-Scholes model.

• Factors like time to expiry and interest rate changes impact IV.

• IV crush is something traders must take into account when trading options.

• Some crypto option strategies that take advantage of implied volatility include strangles, straddles, calendar spreads, and vertical spreads

What is implied volatility?

Implied volatility is a metric that measures the market’s expectation of how much an underlying asset’s price will fluctuate over a specific period. In the crypto market, IV reflects the market’s anticipated volatility of a cryptocurrency’s price. A higher IV suggests that the market expects significant price swings, while a lower IV indicates a more stable price outlook.

For instance, during periods of high market uncertainty or significant news events, IV tends to rise as traders anticipate greater price volatility. Conversely, in calmer market conditions, IV may decrease. Understanding implied volatility is crucial for traders as it helps them assess risk, make informed decisions, and potentially identify trading opportunities. This is especially true in the crypto options space, as IV presents opportunities for both long and short crypto traders.

How is implied volatility calculated? Explaining the Black-Scholes model

Put simply, implied volatility is a statistical measure derived from the option’s price and other factors like the strike price, time to expiration, and the existing risk-free interest rate. It’s essentially a market consensus on how much an asset’s price is expected to move.

For those unaware, IV is generally derived using the Black-Scholes model, a widely used mathematical formula for pricing options. This model takes into account various factors to determine the theoretical price of an option. By comparing the theoretical price to the market price, IV can be calculated and taken into account when making crypto options trades.

In short, the Black-Scholes formula is a mathematical equation that relates the price of a European-style option to the following five variables.

1. Current asset price: The current market price of the underlying asset.

2. Strike price: The price at which the option can be exercised.

3. Time to expiration: The remaining time until the option expires.

4. Risk-free interest rate: The interest rate earned on a risk-free investment like U.S. treasury bills.

5. Implied volatility: The market’s expectation of price volatility.

To calculate IV, crypto option traders will first need to gather the necessary data mentioned above. Then, a bit of mathematical knowhow is required as there’ll be a need to rearrange the Black-Scholes formula and solve the equation for σ, which represents implied volatility. This involves using numerical methods to find the value of σ that makes the calculated option price match the observed market price. Finally, interpretation of the calculated implied volatility is required since a higher IV indicates the market expects greater price fluctuations while a lower IV suggests a more stable price outlook.

Weaknesses when relying on the Black-Scholes model

While some may swear by the Black-Scholes model, here are some things to keep in mind.

• Market efficiency: The Black-Scholes model assumes efficient markets, meaning all available information is reflected in the option’s price. In reality, markets may not always be perfectly efficient since factors such as market sentiment, unexpected news events, or liquidity constraints can cause deviations from the Black-Scholes model's assumptions.

• Volatility: The Black-Scholes model assumes constant volatility for the underlying asset. However, volatility can be quite variable, especially in crypto markets. As such, changes in volatility can significantly impact option prices.

• Transaction costs: The model doesn’t account for transaction costs, which can erode trading gains if you’re actively entering and exiting positions.

• Underlying asset assumptions: The Black-Scholes model assumes that the underlying asset follows a log-normal distribution. If this assumption is violated, the model's accuracy may be compromised.

• Alternative option pricing models: Other option pricing models, such as the binomial option pricing model, can also be used to calculate IV. However, the IV represented by the Black-Scholes model is the predominant one that most traders adopt.

By understanding these limitations, traders can use the Black-Scholes model more effectively and avoid relying solely on its predictions. It’s essential to consider other factors and use the model as one tool among many in your trading arsenal.

In summary, calculating IV involves using the Black-Scholes formula (which you'll find as an appendix to this article, if you're interested). It’s a complex process that requires accurate data and numerical methods. Fortunately, many options platforms today automatically calculate and display implied volatility for various underlying assets, making it easier for traders to assess market expectations and make informed decisions. As such, the barrier to entry for trading crypto options and understanding the basics of IV have been significantly lowered.

Factors affecting IV in crypto options

Now that we’re fully aware of the underlying model used to calculate implied volatility, here’s a breakdown of the several factors that tend to influence IV for crypto options.

• Market sentiment: Positive or negative news about a cryptocurrency can significantly impact its IV. A surge in positive sentiment often leads to higher IV, indicating increased price volatility expectations.

• Time to expiration: As the expiration date of an option approaches, its IV tends to increase. This is because there’s less time for the underlying asset’s price to move significantly, increasing the likelihood of large price swings.

• Volatility index: Indices like the Crypto Volatility Index (CVIX) can provide insights into overall market volatility, which can influence IV.

• Interest rates: Changes in interest rates can impact risk-free rates and the pricing of options, indirectly impacting IV.

What's the relationship between IV and crypto option premiums?

Implied volatility plays a vital role in determining the premium of a crypto option. A higher IV generally leads to a higher option premium, and vice versa. This is because a higher IV indicates a greater expectation of price volatility, increasing the likelihood of the option ending up in the money.

For call options, a higher IV means a higher premium. This is because there’s a greater chance that the underlying cryptocurrency's price will rise above the strike price, making the call option successful.

Similarly, a higher IV increases the premium of put options. This is because there’s a greater chance that the underlying cryptocurrency's price will fall below the strike price, making the put option successful.

What is IV crush?

If you’re new to trading crypto options, chances are you’ve heard of IV crush and how it affects option traders because of the swift decline in option premiums. IV crush occurs when implied volatility (IV) suddenly decreases, leading to a sharp drop in option prices. This can happen when a catalyst doesn’t result in the expected price movement or is less impactful than expected. Some examples of catalysts in the crypto world include huge network upgrades like the Dencun upgrade and regulatory changes like the spot ETH ETF announcement.

The role of catalysts and its impact on implied volatility

Catalysts play a crucial role in IV crushes. When traders anticipate a significant event, they often buy options to hedge their positions or speculate on potential price movements. This increased demand for options pushes up IV and option prices. However, if the event doesn’t materialize as expected, demand for options can quickly evaporate, causing IV and option prices to plummet.

The impact of IV crush on option traders can be severe. For traders who hold long positions in options, a sudden drop in IV can lead to substantial losses. On the other hand, traders who are short-selling options and writing contracts for a premium can benefit from IV crush as option prices decline.

IV crush mitigation tips

Staying informed: Keep up-to-date with relevant news and events that could impact the underlying asset’s price.

Monitoring IV: Track changes in IV to identify potential signs of an IV crush.

Diversifying your portfolio: Don’t put all your eggs in one basket. Consider diversifying your options positions across different underlying assets and expiration dates.

Using stop-loss orders: Set stop-loss orders to limit potential losses if IV were to decline significantly.

By understanding the concept of IV crush and its potential impact, crypto option traders can make more informed decisions and manage their risk effectively in the crypto options market.

How to analyze and interpret IV for crypto options

Analyzing and interpreting IV is essential for successful crypto option trading. Here are some key strategies.

IV charts and indicators

• IV percentile: This indicator shows how high or low IV is compared to its historical range. A high percentile suggests a relatively high IV level.

• IV skew: This measures the asymmetry of the implied volatility curve, indicating potential biases in market expectations.

Using IV trends to identify trading opportunities

• IV compression: When IV is high and then starts to decline, it's known as IV compression. This can be a potential buying opportunity for options as the premium may be inflated.

• IV expansion: When IV is low and then starts to increase, it's known as IV expansion. This can be a potential selling opportunity for options as the premium may be undervalued.

• IV volatility: Trading based on changes in IV itself can be a strategy. For example, a sesasoned crypto options trader may consider buying options when IV is expected to increase and selling them when IV is expected to decline.

Strategies for trading with IV in crypto options

• Straddle: Buying a call and a put option with the same strike price and expiration can be used to make gains from significant price movements in either direction, regardless of the direction.

• Strangle: Buying a call and a put option with different strike prices and the same expiration can be used to make gains from large price movements, but with a lower cost compared to a straddle.

• Calendar spread: Buying an option with a longer expiration and selling an option with a shorter expiration can be used to make gains from changes in IV or the time value of the options.

• Vertical spread: Buying and selling options with different strike prices but the same expiration can be used to create defined risk and reward profiles.

Final word and next steps

Implied volatility is a crucial concept in crypto options trading. Understanding how IV impacts option premiums and utilizing various strategies can help traders capitalize on market opportunities. However, it's essential to manage risks and carefully analyze IV movements to make informed trading decisions in a market that's as volatile as crypto.

Keen to learn more about crypto options strategies? Check out our guide to the options wheel strategy that combines cash-secured puts and covered calls.

Appendix: Black-Scholes formula

C = S * N(d1) - K * e^(-rt) * N(d2)

P = K * e^(-rt) * N(-d2) - S * N(-d1)

C is the price of a call option.

P is the price of a put option.

S is the current price of the underlying asset.

K is the strike price of the option.

r is the risk-free interest rate.

t is the time to expiration (in years).

N is the cumulative distribution function of the standard normal distribution.

d1 = [ln(S/K) + (r + σ²/2) * t] / (σ * √t)

d2 = d1 - σ * √t

d1 represents the probability that the underlying asset’s price will end up above the strike price at expiration.

d2 represents the probability that the underlying asset’s price will end up below the strike price at expiration.

σ is the volatility of the underlying asset