Trading Options: Implied Volatility 101

One of the first questions that a new student typically inquires about is the concept of implied volatility.  What is it and more importantly how do we use concept in our signal methodology?  Think about implied volatility as a proxy for standard deviation. 

A stock with an implied volatility of 50% means that the market "thinks" with a confidence level of ~67% that the stock will be +/- 50% from the present price (one SD) at the end of one year.  Statistically, 95% of the time at the end of the year the stock will be within two SDs.  And just 1% of the time will the stock be 3 standard deviations from the present price at the end of the year. 

Trading Ideas

How does IV figures into our signal methodology?  Often, we are asked by a student something like: "I see that the IV of stock XYZ is high, should we sell it?"  Our answer is: "high when compared to what?"  The most important thing to consider is context.  The implied volatility of a stock like Kuerig Green Mountain (GMCR) is ~86% cannot be compared to a company like Johnson and Johnson (JNJ) which has an implied vol of ~15%. 

Historical Comparisons

How do we know which one is in fact more expensive/cheap?  Initially, we look at IV in comparison to historical volatility.  Historical volatility is the actual realized volatility measured over some time period.  If GMCR has an IV of ~86% and an historical volatility of 50%, then IV would be considered "rich" or theoretically expensive.  If IV<HV we would call IV 'cheap" or "lean".  There may be a reason why IV is lean or rich compared to HV during the trading cycle.  It may be considered rich if there is a pending corporate action, earnings report, regulatory ruling, etc.  There is more fear premium put into implied volatility than is being realized in actual price movements. 

People are willing to pay more for the chance for a move in the future than what is actually happening today. On the other side of the coin, perhaps the stock has just had a big move and is settling into a comfortable trading range.  HV could be much higher than IV but the news is out so people are less willing to pay for fear premium and thus IV<HV.

If there is an anticipated move in the stock due to any of the factors above, the marketplace will pay more for a nearer dated option than for an option whose expiration date is sometime later in time. 

Why Is This? 

An option with a shorter time to expiration will have more gamma.  An option with more gamma will move higher in price quicker as the underlying moves, so it makes it more attractive to own.  The market then adjusts to this supply and demand discrepancy and the shorted dated month's IV will go up.  When this happens, we can weigh the probability of a given move and then determine whether we feel that the different expiration's valuations are out of line.

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