Understanding Why Implied Volatility is Critical When Trading Options

For the trader trying to understand options, it is important to understand the two different concepts of volatility commonly discussed with regards to stocks and their associated options. The importance of understanding the concepts is that volatility in one of its two forms plays a major role in the seemingly inscrutable machinations of options pricing.

The two types of volatility are referred to as statistical volatility and implied volatility. The first type of volatility has little impact on options pricing and is simply a mathematical expression of the magnitude of price variation of a stock over a historical period. This form of volatility is obviously of historic interest and does not reflect future expectations of future price volatility.

The more interesting volatility measure for an options trader is that of implied volatility, often abbreviated as IV. Taken together with price of the underlying and time to expiration, these factors form the three primal forces of the options world. Since price of the underlying is familiar to all traders, time to expiration is obvious to anyone with a calendar, and the “stealth” component of these factors is implied volatility.

Implied volatility is calculated by solving one of the several available options pricing models for this variable. Since price of the underlying is known precisely and the time to expiration is simple to determine, the equation can provide the implied volatility necessary to produce the current price of the option.

An important characteristic of implied volatility is that it is forward looking and reflects the aggregate opinion of future price volatility for the given underlying.   As such, it provides an important insight to help predict the magnitude but not direction of future price movement.

Implied volatility can be ignored only by those option traders with a death wish.  As an example of the danger of not understanding the impact of implied volatility, consider a common story of a trader beginning to trade options.

Thinking that earnings will be strong, he buys a front month at-the-money call option looking to profit from correctly predicting price action after the release.  Following the earnings release, his call he owns reacts little if at all to the price action. Common conclusion: the options markets are rigged and controlled by insiders and offer no potential for profit.

The actual cause of this less than optimal trade is a well recognized and reliably predictable phenomenon that repeats every earnings cycle; implied volatility almost always spikes as earnings approach reflecting an anticipation of significant price volatility as a result of earnings release and forward guidance.

As soon as these data are released, implied volatility typically collapses as the uncertainty surrounding this event has been removed. As a result, option prices are significantly lowered and this collapse in volatility often overwhelms correctly predicted price action and results in a flat or even a losing trade.

Most traders are familiar with the fact that the VIX is reflective of the implied volatility of the SPX index. What is not generally as well known is that individual stocks have historic databases of their implied volatility. Consider for example the chart below presenting the daily historic and implied volatility for the recent past in AAPL.

Several things bear emphasis on the chart above. First, this database refers to historic volatility as statistical volatility (SV)- only the names are different. Second, notice that there is no consistent relationship between historic and implied volatility; at times implied volatility is higher than historic volatility and at other times lower. Third, notice that there are distinct spikes in volatility. In general these correspond to periods immediately before earnings release.

Other spikes in implied volatility correspond with price decreases. Another reliable characteristic of implied volatility is that it is inversely related to price direction. The explanation for this phenomenon is that when price drops traders scramble to buy puts and are willing to pay up for this protection.

As a result of the increased demand, price increases. The mathematics underlying option pricing require parity between puts and call pricing, so the price of the calls increase as well.

Another typical characteristic of implied volatility is that it has a characteristic range for a given underlying. This tendency can provide high probability trading opportunities when volatility spikes well beyond its normal range as a result of some event.

For example, Chesapeake Energy recently exhibited a sharp selloff. Notice the reaction of implied volatility of its options as traders rushed to buy protective puts.

As a result of this spike in implied volatility, I was able to sell Jun 10 puts, a strike far away from the then current price of $15.29. This trade had a 94% probability of profit at expiration. As price stabilized and implied volatility came down, I was able to close the trade for a 78% realized profit based on the funds encumbered by margin requirements.

Understanding and accounting for the behavior of implied volatility is essential for the options trader. Not to consider this factor in trades is a major error for beginning option traders. In the future, refrain from making this very common mistake.

Have a safe and enjoyable Memorial Day Weekend!

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Jw Jones

This material should not be considered investment advice. J.W. Jones is not a registered investment advisor. Under no circumstances should any content from this article or the OptionsTradingSignals.com website be used or interpreted as a recommendation to buy or sell any type of security or commodity contract. This material is not a solicitation for a trading approach to financial markets. Any investment decisions must in all cases be made by the reader or by his or her registered investment advisor. This information is for educational purposes only.