Understanding Implied Volatility

For this month’s article in the coaching corner, I’d like to address a basic understanding of implied volatility. Implied Volatility, often referred to as IV, is an integral part of options trading – it’s at the heart and soul of many traders’ trading repertoire. Implied volatility ranks as one of the most important price determinants of a stock’s options, second to only the price of the stock itself.

According to one online dictionary source, volatility is defined as “tending to vary often or widely, as in price.” As traders, we’re technically always trying to anticipate how much a stock might or might not vary in price. Thus, implied volatility is derived as the study of “how much” or “how little” expectation is being placed upon that potential movement of a stock by current price data.

To put it in layman terms, Implied Volatility estimates a stock’s possible movement potential, either up or down. The higher the Implied Volatility, the more the stock is expected to move, driving up the extrinsic value and price of the options due to a greater possibility that it will end up moving in your favor. The inverse is also true; the lower the Implied volatility, the more stagnant the stock is expected to be, which drives down the extrinsic value and price of the options.

Understanding the direct correlation of IV to option pricing is crucial as well. First, if you’re an option seller like Preston, you need to ask yourself, “Do I want to be selling my options when IV is high or when IV is low?” It’s kind of a trick question depending on the time frame you are doing your trade. For a one-time quick-sell of juiced up IV, the answer would be when IV is peaking. However, the majority of Preston’s trades are swing trades that last numerous weeks, with short-term sold legs positioned against long-term protection. Thus, we would rather sell our options when IV is ramping up in the future, not falling. Selling your options while the IV is declining can be harmful on future premium expectations and the decay of your longer-term bought option premium.

Coaching clients always want to know how they can measure the underlying asset’s implied volatility to know that they’re timing the rise or fall of IV appropriately. There’s a study most trading platforms offer (generally found within their indicator list) demonstrating the measure of implied volatility on a graph for the underlying asset. I’ve included a picture of one of these graphs below from Trade Monster, conveying a 12-month volatility chart for NFLX. The orange line represents the implied volatility in this graph and the blue line represents historical volatility, which is not nearly as important in the pricing of options.

You can gather from this picture that the IV line has created some support and resistance levels (represented by the thin red horizontal lines) over the past 12 months. The support and resistance correspond with 80 percent IV and 40 percent IV, respectively – providing the stock’s common IV range. Thus, we can say that if the stock’s IV is near 80 percent, its implied volatility is high or peaking. Inversely, if the stock’s IV is near 40 percent, its implied volatility is low or bottoming out.

Keep in mind that every stock’s implied volatility is unique, so what might be low for one stock could very well be high for another. I personally like to break the graph up into thirds. When the stock’s implied volatility is in the bottom third of the IV range, I know I’m not getting into a position where my options are overpriced if I happen to be buying options or setting up a money-press trade.

Hopefully you now have a better understanding of implied volatility and will find use for it in your future trading. Further discussions of how to use implied volatility in your trading, and how it correlates to the option Greek known as Vega, can be future topics to explore in this very extensive options topic.