Options 101: Understanding Implied Volatility
Volatility can be measured in a number of different ways, but for investors in the options market, none of the measures are more important than implied volatility [IV]. It not only tells how much an investment is expected to move, but also whether an options contract is “cheap” or “expensive.”
Volatility is term that simply means the speed of movement of an investment. Some, like bonds, tend to move more slowly and have low levels of volatility. Others, like some of the low-priced banks and autos in early 2009, move fast and have high levels of volatility. Because the options market is relatively efficient, the options prices or “premiums” normally reflect the volatility of the underlying asset. For example, prices of SPDR Gold Trust (GLD) options reflect the volatility associated with GLD options and options on BofA (BAC) have premiums that correspond to BAC’s volatility. All else being equal, the asset with higher volatility will have higher premiums than the one with low volatility. Why? Consider this: if two stocks are both trading for $20 and one (Stock A) has been in a $21 to $23 range over the past six months, while the other (Stock B) has traded in a $10 to $40 range, which one is more likely to trade above $25 over the next six months? Probably the more volatile one, or Stock B. Therefore, a call option with a $25 strike will be worth more on the higher volatility stock, or Stock B. That $25 call is more likely to be in-the-money at expiration compared to Stock A, which has been in trading in a narrow $2 range below $25.
Implied volatility is the mathematical measure that quantifies the level of volatility in a given options contract. Computed using an options-pricing model (but also widely available on a number of options-related web sites like here), it is computed as a percentage. Importantly, not only does each options contract have a unique level of implied volatility, but it is always changing. In addition, since the options market is efficient, IV will often change to reflect expectations about future volatility of an investment. For example, implied volatility will often move higher before an earnings report, which can cause a big move in shares of the company. Then, once the event has passed, implied volatility will often fall.
When there is a surge in demand for a specific options contract, it will often cause the premium to rise and this is sometimes called a “volatility rush”. As the premiums get jacked up, the options become expensive or rich. On the other hand, when there is heavy selling in an options contracts, this can cause premiums to fall, which is sometimes called a “volatility crush”. Therefore tracking changes in implied volatility is important because it can tell you, what the market expects regarding the future volatility of an investment and also whether the premiums are cheap or expensive. From there, the strategist can isolate the options strategies that offer the best risk-rewards; which will be a topic of discussion for an installment of Options 201. Click here for past installments of Options 101.
Category: All Indexes, Trading Education, Uncategorized
Free Newsletter
If you enjoyed this article, sign up to receive more just like it.
About the Author (Author Profile)
Frederic Ruffy is a well-known trader, writer, and strategist who has spent years educating investors and creating intelligent, insightful, unbiased market observations that are frequently cited by the Wall Street Journal and other financial publications. As senior analyst, Fred provides frequent and regular notes and daily updates for activity of interest.
