Implied volatility, or IV, is one of the major factors that influences the price of an option. In the simplest terms, implied volatility is a forward-looking metric measuring the market's expectations for the underlying equity's performance during the life span of the option.
Conventional wisdom dictates that higher IV correlates with bearish price action, while lower IV is associated with bullish price action. However, it's not quite that simple.
Instead, implied volatility might best be described as a reflection of the level of uncertainty over the stock's future price direction. For example, if a stock has been trending lower on the charts for some time, IV might be relatively muted, since the bearish price action has been widely accepted as a trend by the majority of investors.
Plus -- regardless of the equity's direction -- IV tends to rise ahead of scheduled events, such as earnings reports, regulatory rulings, or product launches. These types of events have the ability to spark major moves or directional changes in the underlying stock, and the expectation of a post-event reaction pushes IV higher. After the catalyst passes, IV will immediately deflate, as traders price their reactions directly into the shares.
It's crucial for options traders to be aware of implied volatility fluctuations, because this metric plays such a substantial role in determining the option's value. As a general rule, option buyers should be wary of situations where IV appears to be running high, since this will increase the cost of entry and breakeven point on the trade. On the other hand, option sellers may want to capitalize on scenarios where IV is inflated, as a way of maximizing the premium collected.
For a rough guide as to whether implied volatility is running high, low, or right on par, an option's IV can be compared against the stock's historical volatility (HV) for a comparable time frame. If IV is significantly higher than HV, it could signal a situation where IV is inflated. When IV is notably lower, it may indicate an opportunity for option buyers to find some relative bargains.
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