Term Structure of Implied Volatility

The term structure of implied volatility can help investors judge the best option strike dates.

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Term structure is a way for investors to view the implied volatility of options. The term structure shows how the maturity date of an option will change the implied volatility over time. It is generally represented as a curve and helps investors judge whether the price of the option will change in the future. Options with nearer expiration dates will have faster changes in prices than implied volatility of options with longer terms.

Implied Volatility

Implied volatility forecasts the range of possible change in a stock’s price over a period of time. Implied volatility tracks the percentage of change in the stock price, but not the direction of the change. It’s useful for investors to gauge how big a stock’s price will swing. A stock with a high implied volatility tells investors that its price could dramatically swing higher or lower in future trading.

Implied Volatility for Options

Investors use implied volatility to help judge prices for option contracts. Options are investment contracts where a stockholder will agree to sell shares at a set “strike” price and date. The contract, or option, includes a premium price that will vary, depending on how close the stock is to meeting the stock price. With implied volatility, an investor can better judge whether there’s a chance a stock will be higher or lower than the strike price when the option expires. If a stock is likely to beat the option’s price, then the premium price for the option would likely be higher, but it could also be worth the price for an “in the money” option.

Term Structure of Implied Volatility

The term structure of implied volatility describes the pattern of options with the same strike price but different maturities. By looking at term structures of implied volatility, investors can get a better expectation of whether an option with a short-term expiration date will rise or fall in the future. If the term structure is rising, where the implied volatility of long-term options are higher than that of short-term options, then it’s expected that short-term implied volatility is expected to rise. If the implied volatility of short-term options is lower than those for long-term options, then short-term volatility is expected to fall, according to the Northern Finance Association.

Upward and Downward Slopes

Investors can use term structure to help determine when options might see the most volatility, making it easier to plan on which months will provide the best strike dates. The term structure of volatility can have a “downward slope,” with higher volatilities skewing to the near-term option strike dates, or an “upward slope” if higher volatilities are found in long-term strike dates. By analyzing term structure, a trader can find the options with the least-expensive volatility or sell options with the highest implied volatility available.