Implied Volatility With Options Explained (Simple Guide)
If you’re serious about trading options, then you need to understand implied volatility (or IV).
Why? Because it’s a stat that helps you place winning trades.
If you don’t pay attention to IV, you could end up buying high or selling low. In either case, you’re more likely to lose money than if you bought low or sold high.
In this guide, I’ll explain implied volatility so you can use it to make money with options.
What Is Implied Volatility?
Implied volatility is a statistical measurement that attempts to predict how much a stock price will move in the coming year.
It’s expressed as a percentage.
Right now, for example, the Microsoft $100 call option that expires in about a month has an IV of 34%. Microsoft stock is currently trading at $100 per share.
What does that mean? It means that there’s about a 68% chance that Microsoft stock is expected to land within a range of plus or minus 34% of its current share price in one year.
So, a year from now, there’s a 68% chance that Microsoft stock will be as low as $66 ($100 – $34) or as high as $134 ($100 + $34).
Where did the $34 come from? It’s a simple calculation of the implied volatility multiplied by the share price (34% x $100 = $34).
In statistics, that “68% chance” is called one standard deviation. (It’s really 68.2%, for the record).
Of course, now would be a good time to remember the old saying about lies, damned lies, and statistics.
Just because there’s a 68% chance that something will happen, that doesn’t mean it will happen.
One year from now, Microsoft shares could tank to $14. Or they could skyrocket to $170.
But the odds are favorable that it will land within the range specified by the implied volatility.
Implied Volatility vs. Historical Volatility
It’s important to keep in mind that implied volatility is not the same as historical volatility.
Implied volatility makes predictions about future volatility.
Historical volatility tells you about past volatility.
Both implied volatility and historical volatility are expressed on an annualized basis.
No Direction Known
Some people are under the impression that volatility has a downward bias. In other words, the more volatile a stock is, the more likely it is to drop in price.
That’s not the case. Volatility simply measures the change in price. It doesn’t care about direction.
Recall the example from Microsoft above. The implied volatility calculation showed that there’s a 68% chance the stock could go as low as $66 or as high as $134 in one year.
Volatility measures fluctuation, not direction.
Read Also: What Is An Option’s Theta?
What Does All of This Have to Do With Options?
At this point, you might be wondering what all of this has to do with options.
Quite a bit, actually.
Here’s the short version: option prices will usually increase as implied volatility increases and decrease as implied volatility decreases.
Why is that the case? Because many investors use options as insurance policies. They’ll trade call options and put options to hedge their stock positions.
If there’s more anticipated volatility associated with a stock, then there’s more risk associated with it. Since options function like insurance policies, they get more expensive when there’s more risk involved.
Options with high IV have a high premium added to their prices. They’re expensive relative to the same kinds of options for the same underlying stock.
On the other hand, options with low IV will have a smaller premium. They’re more affordable relative to the same kinds of options for the same underlying stock.
By the way, when IV increases that’s called IV expansion.
When IV decreases that’s called IV contraction.
The extent to which implied volatility affects the price of an option contract is determined by vega. That’s one of “the Greeks” that traders often use to analyze options.
Learning the Hard Way: Right Before Earnings
Some new options traders think they can outwit the market by purchasing options right before earnings and then reaping the rewards when the underlying stock price swings wildly one way or the other.
Often, they get burned.
Why? Think about: it’s already baked into the cake that the underlying stock price could make a large move in either direction after earnings.
As a result, implied volatility tends to be high right before earnings are announced. Then, it drops after earnings when the price stabilizes.
So those new options traders made the mistake of buying an option when the IV was high. Then, when the IV dropped, they watched in frustration as their option prices dropped with it.
Please note; even if those options traders were right about the direction of the underlying stock, they still lost money because implied volatility tanked. In other words, even if they bought a call option anticipating the stock to rise after earnings, and their predictions came true, they still lost money because of the drop in IV.
That’s the kind of mistake you can make when you don’t pay attention to implied volatility.
Read Also: How Does An Options Strike Price Work?
Buying Low and Selling High
As a practical matter, use implied volatility to help determine when to get in and get out of options trades.
If you’re bullish on a stock and see that it has a low IV relative to its own history, that’s a candidate for long call option or a multi-leg trade designed to make money when the underlying stock goes up.
Similarly, if you’re bearish on a stock and see that it has a high IV relative to its own history, that’s a candidate for a short call option or a multi-leg trade designed to make money when the underlying stock goes down.
Keep in mind: it’s very important to compare the implied volatility of a stock only with its own history. A “high” IV for one stock might not be a high IV for another stock.
In a nutshell, it’s usually better to sell options when the implied volatility is high and buy options when the implied volatility is low.
What About Options Contracts That Expire in Less Than a Year?
As I pointed out in the beginning, implied volatility is measured on an annualized basis.
If you’re an active options trader, you usually won’t buy options that expire in a year. You’ll probably trade options that expire in 30-90 days.
So how do you calculate the projected price move for that duration?
Here’s a quick and dirty formula that can help you:
- Take the square root of the days to expiration
- Multiply it by the implied volatility
- Multiply that by the stock price
- Then, divide the whole product by the square root of 365 (about 19.1)
So, continuing with the Microsoft example from the beginning. The days to expiration is 28. The square root of 28 is 5.29.
We’ll multiply that by 34% (the implied volatility) to get 1.799 (5.29 x .34).
Next, we’ll multiply that by the stock price to get 179.9 (100 x 1.799).
Finally, we’ll divide that number by 19.1. That gives us 9.41.
So at options expiration, there’s a 68% chance that Microsoft shares will trade as low as $90.59 ($100 – $9.41) or as high as $109.41 ($100 + $9.41).
Keep in mind, that statistical model isn’t perfect. But it will give you a decent estimate.