The One Thing You Must Know When Trading Options – Implied Volatility

No … it’s not the option Greeks.

As you probably know, options are not the same as stocks (no surprise there, hopefully!).

When you buy a stock and it goes up … you profit.

When you sell a stock short and it goes lower … you profit.

Simple enough, right?

However, options don’t act in this fashion … one of the biggest reasons behind people losing their shirts when they first start trading options is they try to trade options the same way as stocks.

Have you ever bought an option, were right on direction and still lost money?

Have you ever bought an option, were wrong on direction … and somehow the trade was profitable?

That’s the strange thing about trading options, sometimes you could be right and lose money or wrong and make money.

Creating success with options is like baking a cake. You need the recipe and you must measure the ingredients correctly … if not, your cake is not going to turn out that good.

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A stock option derives its value from the underlying stock price. However, there is another major ingredient in the mix of how options are priced and the major influence of that pricing is …

Implied Volatility!

Over the years, I’ve seen so many people start out just buying calls or puts without knowing what implied volatility is, why it cycles or how it affects the pricing of the option they are buying.

What is Implied Volatility?

In regards to options trading, implied volatility (IV) provides the estimated standard deviation for that underlying during a given time period using the pricing of the options.

For example:

Stock A is currently trading at $100 per share, but the last month it traded within a range from $90 to $110.

Stock B is also trading at $100 but the range over the last month has only been from $95 to $105.

Therefore, we could conclude that Stock A has been more volatile than Stock B.

Since the market knows this, Stock A should have a higher implied volatility than Stock B.

An underlying with higher implied volatility indicates a wider implied range over time, whereas an underlying with lower implied volatility indicates a more narrow range.

How is implied volatility determined?

Implied volatility is calculated from the market, that is, using bid and ask prices of options. If there is a lot of buying of options in particular strike prices … implied volatility will start to increase … consequently,

making those options more expensive.

Conversely, if there is a lot of selling of options, the implied volatility will start to decrease … this causes those options to be less expensive.

When there is an increase in market demand, implied volatility increases … thus increasing the overall value of options.

Since measurements of implied volatility indicate human behavior and market sentiment, implied volatility measures are cyclical and tend to ebb and flow.

In other words, implied volatility fluctuates by expanding and contracting, which causes options to increase and decrease in value.

Due to this behavior and changes in the market, implied volatility could be considered mean reverting.

When you buy or sell options, you need to be aware and correct on where implied volatility could be going … or else you could lose money.

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How will implied volatility help you profit?

Earlier, I compared two stocks and their ranges in the previous month. We call this actual or historical volatility. When historical implied volatility is compared to implied volatility, it’s often over-inflated is due to uncertainty or fear.

When you buy options, you need to be right on direction, time and implied volatility.

Generally, when you are selling options, you just need be right on implied volatility decreasing and you want for prices to stay within the expected range.

That is why investors love to sell options because options lose value due to time and decreasing implied volatility.

How do you determine high or low implied volatility?

Now, if you’re hoping to have success with options, you need to understand what makes an option valuable and how to determine the value of an option.

Implied volatility is a major component of how options are priced. The higher the IV, the more valuable the option.

As we know, the implied volatility of one underlying stock shouldn’t be compared to the IV of another underlying stock. Rather, the implied volatility of an underlying stock should be compared to its past IV data.

Now, to determine if an underlying stock’s implied volatility is high or low (and whether you should be buying or selling), you must look at its IV rank. The IV rank is an analytics tool offered on the trading platform, which I use, thinkorswim by TD Ameritrade. The IV rank tells us whether the implied volatility is high or low in an underlying stock, based on its IV data over a certain period of time.

In other words, the implied volatility rank allows you to compare an underlying stock’s current implied volatility to its historical implied volatility, over a specified time frame.

The time frame I usually use is 52 weeks because it provides a wide range of IV data. With the IV rank, you could gauge whether current levels are high or low.

52 Week Range of Implied Volatility of S&P 500

52 Week Range of Implied Volatility of S&P 500

In the past, I’ve written about how tastytrade’s research found that an IV rank of 50% or more is ideal when selling option premium. However, implied levels could continue higher … but this provides an ideal area to put on risk, if you believe implied volatility will revert to the mean.

Applying Implied Volatility

I discussed a lot in this article, but once you understand implied volatility and learn how to determine the ideal spot to buy or sell options, you will start to see better results.

I created a free 10 Step Option Trade Checklist … in this checklist, I explain my process and how I determine what trades are the best and which strategy to use for these trades.

It’s a great cheat sheet to have sitting at your computer … at all times.

Do you have any questions about implied volatility? Any stories about how long it took you to finally understand implied volatility, after missing out on profits or booking losses?

… leave your comment below and we will rap about it…

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