How to Use Implied Volatility to Maximize Profits with Options

Implied volatility (IV) measures the market's expectation for the volatility of an underlying stock during an option's lifetime. Knowledge of IV is especially important for option investors, as it is factored into an option's price. Or, in simpler terms, IV can provide clues to as to whether an option is "a bargain," and dramatic fluctuations in IV can affect an option player's bottom line in more ways than one. 

A high IV is typically associated a higher level of uncertainty of which direction the underlying equity will move, and is also associated with a higher cost of entry for option buyers, and a higher premium collected for sellers. Conversely, low IV indicates relatively muted expectations for the stock's future price action, and is generally associated with lower premiums. To shed some more light on the concept and uses of implied volatility, I sat down for a Q&A with Schaeffer's Senior Quantitative Analyst Rocky White and Schaeffer's Quantitative Analyst Chris Prybal.

How do you know when implied volatility is running high or dwindling?  

Here at Schaeffer's Investment Research, we have the privilege of having IV annual range calculations, which allow the user to compare current IVs to that of the past year. We can also tailor this calculation to go back further in time for emphasis or statistical usage. IV most always picks up around known events, conferences, announcements, earnings, news, and so on. 

How does Schaeffer's Volatility Index (SVI) differ from a stock's 30-day at-the-money implied volatility (30-day ATM IV)?

SVI and 30-day ATM IV are pretty close to the same thing, and they are meant to provide the same information (the short-term IVs on a stock). I’m guessing that the 30-day ATM IV uses a weighted average of two expiration dates to find an implied volatility that is exactly 30 days away. 

For example, say you have a stock that has an expiration date 25 days away, with an IV of 20%, and another expiration date 35 days away with an IV of 30%. In that case, you’d calculate the 30-day IV of 25%, right in between them, since they are both the same number of days away from 30 days. 

Our SVI, on the other hand, uses just one expiration date. It always uses the front regular monthly expiration, and finds the ATM IV of that option (once the front-month regular monthly expiration gets within a week it proceeds to the next month, because IVs can get pretty unstable the closer you get to the expiration date).  

Which options strategies would you consider employing when IV is high? 

Premium-selling strategies -- covered calls, put writes, certain spread strategies -- allow you to use the elevated IV to your advantage, knowing that ultimately it is mean-reverting (given enough time).

Which options strategies would you avoid when IV is high? 

Premium buying is much more difficult with elevated levels of IV. As noted earlier, elevated IVs are usually the result of a newsworthy event or highly volatile situation. An investor can be right on picking the direction of a move in these situations, and still lose on the said option contract because IVs collapse after the event passes, which reduces the price of the option (net-net of any directional movement). In this situation, you would need the price movement to outweigh the IV plunge. Due to this challenge, it is often difficult to make money by buying options which exhibit elevated IVs.

Are there any recent examples where you have used implied volatility to make a successful trade?

We recently made a 100% profit on Lockheed Martin Corporation (NYSE:LMT) calls in one of our Weekend Trader services. We specifically stated that "Now appears to be a good time to buy premium on short-term LMT options, with its 30-day at-the-money implied volatility of 13.2% sitting in the low 2nd annual percentile, and its Schaeffer's Volatility Index (SVI) of 12% at a 12-month low."

Is there a rule of thumb for when IV is either a useful or not-useful metric?

Monitoring IVs and successfully trading the movement of IVs is second only to monitoring price action. It is always a useful metric, and never to be avoided unless one wants to trade against known odds and probabilities.