How You Can Tell When Implied Volatility Is Running High

How to make the most of implied and historical volatility in your trading

Sep 11, 2015 at 12:23 PM
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    When implied volatility is over-inflated, option premiums rise -- which raises the cost you pay to play long puts and calls. And when your cost of entry is high, it also hikes your total dollars at risk and your breakeven point on the trade.

    So how can you tell whether IV is running hot? One simple method involves comparing the IV for your option against the stock's historical volatility (HV) for a comparable time period.

    For example: If you're considering a November-dated option that expires in about two months, compare the contract's IV level against the security's two-month HV. If the IV is 51% and two-month HV is 67%, that means your November contract is affordably priced, from a volatility standpoint. Conversely, IV of 67% and two-month of HV of 51% would suggest that option premiums are more expensive than usual.

    As an option buyer, you may want to steer clear of situations where IV is significantly higher than the stock's comparable HV. Alternately, you could consider strategies that involve selling options to take advantage of inflated premiums. Rather than buying a long call, you might play a long call spread or sell a short put spread -- or you may even choose to wait until the hype dies down, when IV and option prices alike revert back to more typical levels.

     

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