A Deep Dive into Implied Volatility

Volatility may be one of the most overused words in trading, and when it comes to options, volatility just comes with the territory. However, without volatility measurements or even the ability to measure volatility, the options market would be a market without a heartbeat. And that heartbeat currently pumps its lifeblood to the tune of two types of volatility: historical volatility and implied volatility.

Historical vs. Implied Volatility

Historical volatility or HV is a statistical measurement of the fluctuating price movement in an underlying security during a given period. This measurement is reported as an annualized percentage and, in simplest terms, measures how far a stock's price has fluctuated from its mean. In short, historical volatility measures what the price of a stock has already done.

The chart above shows the historic volatility of the S&P 500 using a ten-day period. Overall, volatility in the market has been high for the past eight months, but you can see how historical volatility rises and falls with price fluctuations.

Implied Volatility or IV is a measurement of the extra value built into the price of an option to help offset potential price fluctuations; the greater the uncertainty of price movement in the future, the bigger the fluff. Implied volatility helps entices somebody to sell an option during uncertain times. Like when the coronavirus hit the world, implied volatility skyrocketed. Nobody had any idea how wild things were going to get, and option sellers required a small fortune implied volatility or fluff to be willing to open a trade.

Implied Volatility and Options

Volatility is the enemy of certainty, and as traders, we are trying to avoid potential risk. The problem is that someone must be willing to sell an option and assume the risk you are trying to avoid. The more risk there is, the more premium that can be required for the option being purchased. This is the premium paid to the seller for being willing to take on additional risk. There are seven factors that factor into the price of an option: type of option, stock price, strike price, the option's expiration date, the interest rate, dividends paid, and implied volatility.

As we have already stated, implied volatility is an unknown or "arbitrary" number. It is a subjective percentage used to define the value of options based on potential risk. When implied volatility is over historical volatility, the options will be more expensive than the theoretical value. When the implied volatility is below historical volatility, the options will be less expensive than the theoretical value.

A quick google search for free implied volatility charts will give you plenty of options for looking at HV vs. IV. I found this link to IVolatility.com on the first page of my search. It has all the information you need when using implied volatility, and with just a quick snapshot, you can see if HV or IV is over the other.

By comparison, we use Schwab as the brokerage for the TSU account. They provide something called Volatility View that can be helpful. It shows the price of the stock, HV, and IV, all on one chart. It gives a clear picture of the volatility situation. 

Using Implied Volatility When Trading

Being able to analyze implied volatility's impact on options is crucial. You need to be able to recognize the trend in implied volatility. Just because it is tracking at 25% fails to translate directly to it being high or low. Because some stocks fluctuate more drastically than others, it is advantageous to compare them to previous measurements. For example, AMZN may have an IV range from 20% to 50%, while AT&T may have a range from 12%- 20%. It is primary to recognize the ranges for the underlying stocks you are watching and adjust your plans accordingly.

Thus, when implied volatility is low, you want to be the one buying the options, and when it is high, you want to sell options. Implied volatility tends to rise in the days leading up to an earnings event and then plummet afterward. That is why strategies like a straddle or strangle over earnings can be challenging to trade. Knowing this little tidbit of information should allow you to collect what I call volatility "tax" - that artificial increase of option pricing leading up to earnings. Let's go back to our Apple example. 

If AAPL is trading at $118.69 and has a one year HV of 40%, you can expect the price to fluctuate between $43.22 and $194.15 in the next 12 months. 40% on either side of the current price. The higher the IV percentage number, the bigger the price swing. You can change the time frame based on the time to expiration.

In closing, if you understand how implied volatility works and how you can use it to your advantage, it can significantly improve your trading. So take a close look at how implied volatility can affect your trading plans and adjust accordingly.