We get asked from time to time about Implied Volatility (IV) values. One common question is: Why does the Upstox IV differ from the NSE (or from other brokers)?
To answer that, let’s take a step back. IV is the ‘implied volatility’ of an option contract. Implied means that it isn’t directly observed and isn’t actual market data. To model the price of an option, you use an option pricing model like the Black-Scholes Model (BSM). The inputs for this model are:
• Current underlying price
• Strike Price
• Time until expiry
• Volatility
• Interest Rate
The output of the model is the estimated option price. If you are a volatility trader, you can make assumptions on what the volatility of the security should be. Maybe you use the standard deviation of the stock’s price moves, a weighted average of that, or something more sophisticated. For volatility traders, your volatility model is your “edge”. If the option’s price from the BSM and your volatility model show that it is significantly higher than the market price, then you potentially have a buying opportunity.
The BSM can also be used to back-into the volatility estimate. There is already a price in the market for the option so instead of using the BSM’s output, you can assume that the BSM’s option price = the current market price for the option. Since the underlying price, interest rate, time, and strike price are known, the only unknown is volatility. This “backed into” value for volatility is IV.
Now, there are some subtle differences in assumptions for the BSM that can be used. For example, here is how Upstox’s assumptions vary from the NSE.
• Option Price: We use the same assumption as the exchange (LTP). However, you could also use the midpoint between the bid and ask price.
• Interest rate: We use the same assumption as the exchange (10%). This is a common assumption. Of course, you can use a different rate.
• Time until expiry: We use different assumptions than the exchange. They use whole days until expiry; we use granular time (ex: 6 days vs. 5.5 days until expiry) making us more technically accurate.
• Underlying Price: We use different assumptions than the exchange. They use the spot price of the underlying and we use the futures price.
Hopefully this makes implied volatility calculations a little easier to understand.