How to Use Implied Volatility to Compare Options Across Strikes

The Big Mistake Most Options Traders Make

Many people learning about what is options trading in India make a common mistake. They look at an option chain and see two different call options for the same stock. One has a premium of 20 rupees. The other has a premium of 90 rupees. They quickly decide the 20-rupee option is "cheaper." This seems logical, but it is often wrong.

The premium is just the sticker price. It doesn’t tell you if you are getting good value. To truly compare options, you need to look at a different number: Implied Volatility (IV). This single number helps you understand the real cost of an option. Using implied volatility to compare options across different strike prices is a skill that separates new traders from experienced ones. It helps you see what the market truly thinks about a stock's future.

First, What Is Implied Volatility?

Implied Volatility is one of the most important concepts in options trading. Think of it as the market’s prediction of how much a stock's price will move in the future. It is not a guarantee, but a measure of expected price swings.

• High IV means the market expects big price movements. This could be up or down. Options will be more expensive because there's a higher chance they will end up in-the-money.
• Low IV means the market expects the stock to be calm, with smaller price movements. Options will be cheaper because the perceived chance of a big move is lower.

IV is shown as a percentage. It is a key input in the formulas that calculate option prices. When you compare IV across different strike prices, you get a much clearer picture of value than by just looking at the premium in rupees.

Step 1: Find the Implied Volatility on an Option Chain

Your first step is to locate the IV data. Every good stockbroker in India provides an option chain for stocks and indices like Nifty 50. In this option chain, you will find several columns of data for both calls and puts.

Look for a column labeled "IV" or "Implied Volatility." It is usually placed next to other key data points like the Last Traded Price (LTP), Open Interest (OI), and the option greeks. This IV number is calculated in real-time based on the current option premium. It is the key piece of information you need for your comparison.

Step 2: Understand the Volatility Smile or Skew

When you look at the IV column, you will notice something interesting. The IV is not the same for all strike prices. It changes as you move away from the current stock price (the at-the-money strike). This pattern is called the volatility smile or volatility skew.

Often, you will see that out-of-the-money (OTM) put options have a higher IV than at-the-money (ATM) or OTM call options. This is because traders are often more fearful of a market crash than they are hopeful of a huge rally. They are willing to pay a higher premium for downside protection, which pushes up the IV on those put options. This common pattern is known as a "skew." Understanding this is vital because it tells you that a baseline level of fear or greed is already priced into the options.

Step 3: Compare Relative IV, Not Absolute Premium

This is the most important step. You must shift your thinking from comparing rupee amounts to comparing IV percentages. An option with a low premium can be “expensive” in volatility terms, and an option with a high premium can be “cheap.”

Let's look at an example. Imagine the Nifty 50 is trading at 23,000. You are looking at two call options expiring on the same day.

At first glance, the 23,400 call looks much cheaper at only 45 rupees. However, its IV is 16%. The 23,200 call has a higher premium of 110 rupees, but its IV is lower at 14%. This means the market has priced a higher expectation of volatility into the 23,400 call. In volatility terms, the 23,400 call is actually more expensive. You are paying more for each unit of expected price swing.

Step 4: Identify Potentially Overpriced or Underpriced Options

By comparing the IV across strikes, you can spot anomalies. The volatility skew should generally be a smooth curve. If you see a sudden, sharp jump in IV for one specific strike price compared to its neighbors, it might be a trading opportunity.

For example, if the IV for strikes around the 23,400 call are all 14.5% but the 23,400 strike itself is at 16%, it might be relatively overpriced. An option seller might see this as an opportunity to sell that specific option, believing its IV will eventually fall back in line with the others.

Conversely, if a particular strike has an unusually low IV, an option buyer might see it as a bargain. This allows you to make decisions based on relative value, not just a gut feeling about the direction of the market.

Step 5: Use Your IV Analysis to Select a Strategy

Your analysis should directly influence your trading strategy. How you use implied volatility to compare options can guide your next move.

• Found an option with very high IV? You might consider selling it. Strategies like writing a covered call or opening a credit spread are designed to profit when volatility (and the option's premium) decreases.
• Found an option with very low IV? You might consider buying it. If you expect a big price move, buying a 'cheap' option in volatility terms can give you a better potential return. Long straddles or strangles are strategies that benefit from an increase in volatility.

Comparing IV helps you choose not only the right direction (bullish or bearish) but also the right tool (which specific option strike) to express that view.

Common Mistakes When Using IV to Compare Options

As you start using IV, be careful to avoid these common errors.

Confusing Implied Volatility with Historical Volatility

Historical Volatility (HV) measures how much the stock price actually moved in the past. Implied Volatility (IV) is about what the market expects for the future. A stock can have low HV but high IV if a major event, like a quarterly earnings report, is coming up.

Assuming IV Is a Perfect Predictor

High IV does not guarantee a large price move will happen. It is simply the market's consensus expectation. The expected move can fail to happen. This is the risk option buyers take and the reason option sellers can profit.

Ignoring Major Events

IV naturally increases before major scheduled events like company earnings, regulatory announcements, or RBI monetary policy meetings. For more information on investor awareness and financial markets, you can visit the SEBI investor portal here. Always be aware of the calendar. A high IV might be perfectly normal right before a big announcement.