What Is Implied Volatility in Crypto Options Trading?

Correctly anticipating the future value of an asset plays a significant role in both the profitability of an investment and in risk management. For many types of investments, such as stocks and real estate, various factors can be reviewed, analyzed and monitored to project what the future value may be. The historical volatility, or realized volatility, of the crypto market has largely been rooted in speculation. Because of this, analysis of implied volatility can be useful in optimizing gains and minimizing the risk associated with crypto options trading.

What Is Implied Volatility?

Implied volatility (IV) is a metric that’s utilized to predict what the market is expecting from an underlying asset’s future price movement. While it cannot exactly predict price movement, it can provide a strong indication of what may happen in financial markets.

The crypto market is well-known for its extreme historical volatility, which has presented investors with incredible opportunities for financial gain. However, this potential gain is based on predicting whether the market price will go up or down and how far the price may swing. Because of the strong element of speculation that drives crypto price volatility, the risk of loss is also substantial. Implied volatility is a means of assessing price fluctuations while taking market risk into account. A decline in implied volatility typically occurs when the market is bullish. An increase in implied volatility, on the other hand, occurs when the market turns bearish.

Because implied volatility anticipates trading volume and market sentiment, it’s used for options trading rather than for traditional buy and sell orders. In the cryptocurrency market, the cryptocurrency volatility index, or CVI, is comparable to the CBOE Volatility Index, a 30-day projection of the overall market used in stock market trading.

How Does Implied Volatility Work?

When calculating implied volatility, you can gauge market risk and determine fair options pricing using the Black-Scholes model. You can also determine if the projected future volatility level is higher or lower than the realized volatility, and gain a deeper understanding of sentiment for that asset in the financial markets. 

High implied volatility usually means that market conditions are changing rapidly. This may be associated with sharp price dips and peaks. Lower implied volatility is often associated with less extreme dips and peaks. Implied volatility is used to gauge market sentiment so that an investor may better anticipate the profit potential for a specific crypto options contract.

How Is Implied Volatility (IV) Calculated?

Anticipating the price movement of an underlying asset is essential for risk management. To calculate IV, you use several key factors: The options trading price, the cryptocurrency’s price, the strike price and the option contract expiration date. Without knowing all of these factors, calculating implied volatility isn’t possible.

Calculating IV requires you to input these data points into an options pricing model. One such options pricing model that’s commonly used is Black-Scholes. Notably, this method can also be used to calculate the other factors in the equation if the implied volatility is known. The development of the Black-Scholes method several decades ago directly contributed to the rise in popularity of options trading.

In order to determine if the implied volatility for a specific asset is higher or lower than average, we use implied volatility rank, which looks at the implied volatility for a specific asset over the last 12 months in comparison to its current IV. An implied volatility rank close to 50 indicates that the current implied volatility is on par with the 12-month average.

How Does Implied Volatility Affect Crypto Options?

With options trading, investors predict whether an option's price will increase or decrease over a predetermined period of time. Compared to traditional buy and sell orders, options trading is generally less risky. The options premium is tied to both the time value and to the intrinsic value, which represents the equity in the option. 

For example, assume that your call option is $20 and the option's price is $30. You have the option to purchase at the strike price of $20 and can turn a $10 profit by immediately selling at $30. High implied future volatility is generally associated with a higher options premium. 

The extrinsic value of a crypto asset is rooted in factors other than the market price. For instance, the time remaining until the expiration can drive extrinsic value. Generally, the extrinsic value increases when a market is more volatile.

Implied volatility can be used to anticipate how wide the market value movement of a crypto asset may be, and to better estimate the most strategic times for buying and selling. Higher implied volatility indicates the potential for higher options prices. As a result, an investor may pay a premium to buy a new option contract for that asset. On the other hand, when implied volatility decreases, lower options pricing may follow. Declining implied volatility means that demand for that asset is waning. 

When using implied volatility for options trading, be aware that at-the-money options or options with longer expiration times are typically more price sensitive. Higher price sensitivity means that the strike price is more likely to be on par with market value.

Why Is Implied Volatility Important to Crypto Traders?

Because of the crypto market’s extreme price volatility, the ability to time the market directly affects gains and losses. More than that, it affects the significance of those gains and losses. If you place your trade too early or too late, you could miss out on an otherwise lucrative opportunity, or could even lose money. 

As is the case with other types of assets, it’s impossible to know how the crypto market will move. However, IV gives you a much better idea of the expected movement over a specific period of time. It helps you know when to make a purchase, and what the risk may be.

While implied volatility is important to crypto traders, using it in the crypto market is more complex than using it in other financial markets. This is because there may be missing quotes, low trading volumes and other factors that could skew the results. Generally, ETH and BTC are the only assets with a well-developed options market that’s suitable for implied volatility.

Pros and Cons of Using Implied Volatility

Implied volatility can’t provide you with perfectly accurate market predictions, but it can help you make a highly educated guess based on multiple data points. As a result, it offers exceptional benefits for crypto options trading. However, there are a few downsides to be aware of as well.

Pro: Gauge Market Sentiment

Implied volatility is a predictor of market sentiment. When the financial market is bearish, IV typically declines. On the other hand, if a market is turning bullish, IV may be higher, and swings will typically be wider, even over a shorter period of time.

Pro: Strategize Your Entry Point and Investment Period

Crypto options trading lets you arrange a buy or sell order in advance at a predetermined price and time. A call option gives you the right to buy the asset, and a put option the right to sell. However, there’s no requirement to exercise the right to buy. Success with options trading is strongly based on your timing of buy and sell orders. Implied volatility provides an indication of sentiment for a specific period of time, which enables you to better strategize the timing for your buy and sell orders.

Con: Cannot Predict a Price’s Upward or Downward Movement

During a bull market, crypto prices tend to rise overall. But there are often extreme price fluctuations, and even in a bull market, where implied volatility is high, it’s possible for the market to swing in either direction. While IV can closely predict market sentiment for a given period of time, it cannot determine whether an underlying asset’s price will increase or decrease during that period.

Con: Various Other Factors Also Have an Impact on Prices

While the crypto market is strongly driven by speculation, there are many factors that drive price movement other than the key data points used to calculate implied volatility. For example, the regulation of cryptocurrencies in one country can have a huge impact on prices and volatility throughout the market. Other factors can drive options prices as well, such as social media hype and news stories related to the financial markets.

How to Use Implied Volatility in Crypto Options Trading

Implied volatility can be used to analyze different expiration times. By assessing the trend of different IV measures you can better understand future risk. For example, the implied volatility of BTC between Nov 26 and Dec 2, 2022, shows an overall inverted structure. This indicates increasing risk in the market.

You can also compare the IV for two different crypto assets over the same period of time. For example, a look at the at-the-money IV for both ETH and BTC over the same time period mentioned above reveals that the volatility spread between these assets was roughly 23%.

Implied volatility can also be used to analyze strike prices. For example, in-the-money options are typically more expensive because they may expire without adding value for the trader. At-the-money options have a higher implied volatility and a higher premium, presenting a greater risk to the investor. If the premium were lower, the loss to the investor would be lower given the same circumstances.

The Bottom Line

Options trading involves speculation on the direction of price movement for an underlying asset over a period of time, rather than the actual price of the asset. Implied volatility takes into account several factors in order to provide you with an educated guess on potential movement over a specific period of time. By doing so, it can aid in risk management and help you to determine the most strategic entry and exit points. As a result, implied volatility is a strong metric that can help you make better crypto options trades.

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