An option’s implied volatility level serves as a way to measure market uncertainty and the leverage involved in option pricing. If all else is equal, then underlyings with lower implied volatility levels tend to have lower priced options while underlyings with higher implied volatility levels tend to have higher priced options.
It all goes back to the fact that options are attractive investments for many reasons: they represent a less expensive alternative to owning or shorting stock, and they represent a way to insure your stock against a possible decline in value.
In all of our books, we use a proprietary “down and dirty” formula whereby one can accurately predict how much a stock is statistically expected to move based on its options’ implied volatility. Many people have found this information invaluable when choosing trades.
To understand the relationship between implied volatility and expected stock movement, keep in mind that the purchasing options represents a low cost alternative which takes advantage of stock movement in your preferred direction(s) or insures against stock movement in an adverse direction.
So think about it. If you were using options as a stock substitute, you would want to buy them on a stock that moves a lot…but so would everyone else. Since everyone wants to buy these options, the value of the options will rise. The higher price of the options would be reflected in a higher implied volatility level.
By the same token, if you own a stock that is known for making large moves, you might want to protect it by purchasing options…but so will everyone else who owns the stock. The value of the options will rise to reflect the greater interest in them. The higher price of the options will be reflected in a higher implied volatility level.
Now let’s look at a problem facing an option seller. To review, keep in mind that a trader who sells an option to open a position is usually looking for the option to decay over time so that they can repurchase it for a lower price. This works well in stocks that do not move much; however, in big moving stocks, selling naked options could be lethal. So what happens when traders do not want to sell options in fast moving stocks? The traders must be enticed to sell the options. In other words, the sellers must be satiated at a higher price point. For that to happen, the buyers have to pay more to purchase options from a willing seller. The higher price of the options would be once again reflected in a higher implied volatility level.
From a more mathematical standpoint, implied volatility is measured as the expected move (in percentage terms) that a stock might make over one year’s time. Therefore, a few things must be noted. First, if you are given implied volatility level as a percentage, then the expected move in terms of dollars will increase as the stock price increases. Second, given a fixed stock price, the expected move in terms of dollars will also increase as the implied volatility level percentage increases.
The concept of an option’s implied volatility is at times simple and at times complex. However, a trader who understands this important concept may be able to take advantage of some of the most successful trading techniques available to retail and professional traders alike. Profitable concepts, like Gamma Scalping, can benefit a trader who thoroughly understands implied volatility. For more information, visit our website and refer to the book Option Greeks for Profit.