Volatility is an important factor in pricing options. Traders compare volatility of various strikes for a given expiry to determine whether a strike is rich or cheap. Likewise, they compare the current levels of volatility with historic volatility to determine whether all options on an underlying are currently pricey or not. This week, we discuss what you should be mindful of when you observe the levels of implied volatility across expiries. Volatility graphsA volatility skew graph plots implied volatility across strikes for the same expiry. This graph helps you choose the strike to initiate long or short position. To initiate a long position, you could pick the strike with the lowest implied volatility among five strikes located close to the current underlying price. That would be two immediate in-the-money (ITM) strikes, two immediate out-of-the-money (OTM) strikes and one at-the-money (ATM) strike. You can also graph volatility of a particular strike across expiries. This graph is called term structure of volatility. Analysts structuring over the counter option products combine both volatility skew graph and term structure of volatility to meaningfully price a product. The combined three-dimensional graph is called volatility surface. Time decayOptions traders use a different version of term structure of volatility graph to compare current volatility levels in the market with historic volatility levels. Instead of using the same strike across expiries, traders use ATM strike for each expiry to compare the volatility levels. An ATM strike is the one just above an underlying’s price at any given point in time. How is this graph useful? Suppose you have a positive outlook on an underlying and want to initiate a long position. You observe that the implied volatility of the ATM strike has increased from, say, 12 per cent to 17 per cent over the last three weeks.The increase in implied volatility levels indicates that options are trading rich. Therefore, the risk is that time decay could drag your returns. This could happen because higher implied volatility is a function of higher time value. And higher time value results in larger time decay with each passing day. This could drag the gains from increase in option price associated with the underlying price movement (delta gains). You could choose to instead initiate long futures position, as futures do not suffer from time decay like options do.Optional ReadingYou must first determine the ATM strike for each day when you compare current levels of volatility over time. For instance, if you are interested in observing how the implied volatility of the ATM strike moves over the past three weeks, you should first take the closing price of the underlying for each day over the last three weeks. Then pick the ATM strike for each day and determine its implied volatility using the Black-Scholes-Merton option valuation model. You should then graph the data to understand how the implied volatility of ATM strike has changed over the observed period. (The author offers training programmes for individuals to manage their personal investments)Published on August 22, 2026