What Every Options Trader Needs to Know About Implied Volatility

Overpaying for implied volatility can be a costly mistake for options rookies

Jun 23, 2017 at 11:56 AM

Implied volatility (IV) refers to the expected movement of a security's price over a given time frame. IV is a crucial concept for options traders to understand, since it's a major component of an option's price. Higher IV results in higher option premiums, while low IV often translates into more affordable option prices.

Stock-specific events, such as management changes or earnings reports, can have a big impact on IV. If investors are expecting the stock to make a substantial move in one direction or the other in response to these known events, those expectations will push IV (and, by extension, option prices) higher. In the aftermath of the event, IV tends to decline rapidly as the market's reaction to the news is priced directly into the equity.

When IV spirals lower after an event, it's referred to as a "volatility crush," since options prices can drop so dramatically in such a short time frame. To ensure success in options trading -- and avoid the crush -- it's crucial to avoid buying extraneous volatility.

Before buying an option, it's possible to determine whether IV is relatively inflated by comparing it to the stock's historical volatility (HV). For example, a trader considering an option with one month (roughly 20 trading days) of shelf life would review the contract's IV level against the stock's 20-day HV. If IV is considerably higher than HV, it means expectations for future volatility are getting frothy. This type of situation is far from ideal for options buyers. When premiums are inflated, the upfront cost and total risk are that much steeper, and the stock must then stage an even greater move to surpass breakeven.

Whenever possible, premium buyers should be on the lookout for scenarios where IV appears to be underestimating the stock's ability to break out, as suggested by historical volatility. By keeping entry costs to a minimum, savvy traders can set their breakeven points as low as possible, and make the most of options trading leverage.

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