Stock traders may already be familiar with the concept of volatility, which refers to the propensity of a security's price to move higher or lower. In the world of stocks, volatility is often discussed in terms of beta -- that is, the degree to which a stock is more or less volatile than a broad-market index.
For options traders, understanding volatility takes on a deeper meaning and relevance. That's because implied volatility (IV) is one of the primary factors that determines an option's price. Not only will IV play a major role in how much you pay to buy an option -- or how much you receive for selling an option -- but fluctuations in IV can also determine whether a particular option trade winds up a winner or a loser.
At the most basic level, high (or rising) IV suggests the market is expecting a significant move out of the underlying stock. Conversely, low (or declining) IV indicates relatively muted expectations for the stock's future price action.
When there's a major event in the near future -- such as a product launch, earnings report, or regulatory ruling -- implied volatility will often rise as traders anticipate the stock's reaction to the news. Assuming all other factors are equal, increasing IV will result in higher option premiums.
After the event passes, IV on the stock's options will deflate as the market's reaction to the news is priced directly into the shares. Again, assuming all other things are equal, this drop-off in IV will push option prices lower.
Of course, implied volatility isn't the only factor affecting the value of your option. As you might expect, the price of the stock itself has a major influence on your option's worth, particularly when dealing with in-the-money options. However, rookies have been known to suffer losing trades when they underestimate the impact of implied volatility's ebbs and flows, so it's crucial to understand how this metric will impact your trades before you dive into the world of options.
For a deeper look at various aspects of volatility, pay a visit to our Volatility Basics section.