Today we will look at how high implied volatility improves your options trading performance. When Implied volatility is high, the premium we receive when we sell an option contract can be much higher than when Implied volatility is low.
That means that the credit received for that position is greater at that strike than it would be if the implied volatility were lower.
Without going too deeply into the math, we can say that IV is determined by the current price of option contracts on a particular stock or future. It is represented as a percentage that indicates the annualized expected one range for the stock based on the option prices. For example, an IV of 25% on a $200 stock would represent a one standard deviation range of $50 +/- over the next year.
What does “one standard deviation” mean?
In statistics, one standard deviation is a measurement that encompasses approximately 68.2% of outcomes. When it comes to IV, one standard deviation means that there is a 68% probability of a stock settling within the expected range as determined by option prices. In the example of a $200 stock with an IV of 25%, it would mean that there is an implied 68% probability that the stock is between $150 and $250 in one year.
Why is this important?
Options are insurance contracts, and when the future of an asset becomes more uncertain, there is more demand for insurance on that asset. When applied to stocks, this means that a stock’s options will become more expensive as market participants become more uncertain about that stock’s performance in the future.
When the uncertainty related to a stock increase and the option prices are traded to higher prices, IV will increase. This is sometimes referred to as an “IV expansion.”
On the opposite side of IV expansion is “IV contraction.” This occurs when the fear and uncertainty related to a stock diminishes. As this happens, the stock’s options decrease in price which results in a decrease in IV.
In summary, Implied Volatility is a standardized way to measure the prices of options from stock to stock without having to analyze the actual prices of the options.