It's crucial to know how implied volatility can impact options trades
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.