The implied volatility (IV) of an options contract is the markets view of changes to that contract. Stated another way, IV suggests how much or how little an options contract will change in price.
Implied volatility is a difficult metric to understand for many traders because it isn’t observable in the market. IV is a theoretical figure used to determine an options price, calculated from more predictable metrics.
Typically, those metrics include; price, time until expiration, strike price, and current interest rates. These criteria create the current implied volatility of an option. Thus, the current price of an option.
If IV reaches a relatively high level the options price will follow, making it a better time to sell premium. When IV is relatively low its a better time to buy premium.
Implied Volatility Example
XYZ stock has been crushing the competition in widget sales. A trader expects the earnings release to be positive and the stock to increase in value. So, to participate in this short term bullish sentiment a trader would like to buy a call option. However, given the nature of high IV events, such as an earnings release, buying the call outright wouldn’t be the best trade. The better trade would be to sell a vertical put spread. Therefore, capitalizing on both the increasing stock price and the declining IV value. Without an understanding of IV this trader could have lost money and been absolutely correct in their assumption.
At OptionID we look to implied volatility to find an edge in the options market. This edge will guide our decision making process in favor of or against a specific trade. Each OptionID’d will be complete with an in depth breakdown of IV.
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