Back to Basics: Implied Volatility

How IV impacts option prices

by Emma Duncan

    Published on May 18, 2018 at 2:30 PM

    One of the major factors that influences the price of an option is implied volatility (IV). In simplest terms, implied volatility is the anticipated movement of an underlying equity over a certain time frame. For options traders, its important to be aware of implied volatility and any fluctuations, because this metric plays a substantial role in determining the option's overall value.

    How Does IV Impact Option Prices?

    When looking at options prices, higher implied volatility will result in higher option premiums. For example, IV tends to rise before major events such as earnings, because these events are often catalysts higher or lower for the underlying stock. On the flip side, options tend to suffer a "volatility crush" after the company reports. Following the event, the news is priced directly into the shares, and the "uncertainty premium" drops out of the option price.  

    How Can You Tell When IV is Inflated?

    To know whether or not a stock's IV is inflated, you would need to compare it to the equity's historical volatility (HV). HV is the backwards-looking metric that looks at a time frame from the past to measure how much movement a stock experienced. The time frames of HV and IV should be similar when comparing -- e.g., a 30-day HV to a 30-day option.

    Option buyers should be wary when IV appears to be running much higher than HV, as that could mean options are overpricing volatility expectations. Option sellers, meanwhile, could capitalize when IV is inflated, as higher option prices mean more premium received at initiation.

    Tools and Tips for Finding Attractively Priced Short-Term Options

    There are also great tools to help you find an attractively priced short-term options. These include our Schaeffer's Volatility Index (SVI), and Schaeffer's Volatility Scorecard (SVS).

    The SVI is a forward-looking tool, which measures the average at-the-money (ATM) IV of a stock's front-month options, while also giving an annual percentage ranking. An SVI near the bottom of its annual range indicates short-term options are pricing in relatively low volatility expectations.

    SVS is a backwards-looking proprietary indicator that measures a stock's realized volatility against the volatility expectations priced into that stock's options over the past year. The goal is to find which stocks have been the best -- and worst -- for premium buyers. A stock with a high SVS is one that has exceeded options traders' volatility expectations historically.

    Other tips when looking for an attractively priced options:

    • Check the security's charts for key support and resistance levels that could help or hinder your trade.
    • Be aware of any major volatility expectations that have already been priced in.
    • Select your options with consideration, making sure to choose the right time frame and strike price for your risk tolerance.
    • Have an exit plan, and determine your target profit and stop-loss in advance.  

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