Implied volatility is often one of the last concepts rookie stock option traders conquer. And that’s unfortunate, as “IV” is often the most important driver of an option’s price.
Those who wait to wrangle the subject of volatility often make costly errors in their trading. Perhaps the blame lies with the intimidating nature of the topic. Or, perhaps these enthusiastic new traders were turned off by early exposure to discussions on IV that turned overly complex.
Regardless of the reason, today’s missive will explain implied volatility in the simplest terms possible.
So fear not, dear reader, here is everything you need to know about IV in roughly 700 words.
What Is Implied Volatility?
Implied volatility measures the supply and demand for an option. If demand for an option rises what happens to the price of the option? All else being equal, it rises — as would any freely traded product when demand surges. As the option premium inflates, so too does IV.
Now, what happens to the price of an option if supply rises? All else being equal, it falls. And as the option premium deflates, so too does implied volatility.
Stock option traders track IV to get a sense of how cheap or expensive prices have become. When implied volatility is high, it suggests options are relatively expensive … and when it’s low, it suggests options are relatively cheap.
Pick a Side
Remember, options can be both bought and sold when initiating a new position. If you’re bullish on Apple Inc. (NASDAQ:AAPL), you can get long through buying calls or selling puts.
How do you choose?
Well, what if I told you AAPL options were the cheapest they’ve been all year? I bet you’d want to buy them.
On the flipside, what if I told you Apple options were quite expensive right now? I bet you’d want to sell them.
What’s more, when you are long options, you want to see implied volatility rise throughout the trade. That means demand for the option is rising, which naturally will inflate its price. This is why when you buy an option, we say you are long volatility.
When you sell options you want to see implied volatility fall throughout the trade. That means supply of the option is rising — or demand is falling — which will deflate its price. This is why when you sell an option we say you are short volatility.
Now you should see why the current level of implied volatility is used by pro traders for strategy selection.
Implied Volatility: Mean Reversion
The behavior of implied volatility is relatively consistent. While it’s not as precise as a clock, it’s also not as unpredictable as an inmate. Its behavior parallels that of the weather, easy to forecast the general climate but not the day-to-day vagaries.
IV exhibits mean reversion. That’s fancy-pants speak for it keeps returning to some average level over time. As a result, it’s easiest to predict at extremes. When implied volatility climbs too high, it’s a good bet it will head lower over time. When it descends too low, it’s a good bet it will head higher over time. The undying gravitational pull of implied volatility’s mean makes its behavior quite a bit easier to predict than a stock’s price.
Most charting platforms include implied volatility among their suite of tools. You can chart it alongside your stock charts to quickly assess whether options are cheap or expensive and, in turn, better select the appropriate strategy.
Consider the following chart from a few months ago that shows the price of Apple in the top panel, and the implied volatility for AAPL stock options in the lower panel.
Click to Enlarge
Take note of how the implied volatility has exhibited mean reversion over the past year. The periods where IV was low were the most attractive to initiate long volatility strategies like buying call options, vertical debit spreads or straddles. The periods where IV was high were the most attractive to enter short volatility strategies like selling put options, vertical credit spreads, or iron condors.
If you’re serious about trading stock options, then start using implied volatility. It provides an edge you don’t want to miss out on.
