Using Implied volatility can be a game changer in your trading strategy to maximize your profits. Implied volatility is best used in options trading. It is the measure of the market’s expectation for volatility throughout the options lifetime on its underlying asset. Whether it’s stock on an ETF.
Implied Volatility Options
The implied volatility in options can tell the investor or trader what the value of the option may be. High implied volatility reflects higher degrees of uncertainty, which is also reflected in the increased cost of the option. Options buyers will have to pay more for high implied volatility (IV) and options contract sellers will receive more premium for writing options.
On the opposite end, low IV means that there are very low expectations of future asset fluctuation and is associated with lower premiums. That means options buyers will pay less and options sellers will receive less.
Every option differs in its sensitivity to implied volatility changes. Short-dated options expiry are less sensitive to the change in IV. Long-dated options expiry are more sensitive to change in IV. The main reason for this difference is that long-dated options expiries have more time values that are priced in.
Options continue to get more and more complex because the option’s strike also affects how the price will change in response to IV. Options with strike prices near the money are most sensitive to IV changes. Options that are far in the money or far out of the money are less sensitive to IV changes. The options implied volatility is represented by the Greek symbol-Vega. This shows traders and investors the option’s sensitivity to IV changes. The Vega denomination changes over time, increasing or decreasing the sensitivity of an option toward IV changes.
Implied Volatility (IV) Example
Take this option example. If you own options whether their puts or calls and you see a massive spike in the implied volatility, the price of those options will climb. Even if there is no immediate directional move. Or even if there’s a slight directional move against your position you will notice a slight increase in your options worth. Unfortunately, to the opposite end, if you notice a decrease in IV and you’re holding a long options position even if the price of the underlying moves in your direction you will see a slight decrease in your options worth.
How to use Implied Volatility to maximize your profits
Even in options, and all the Greeks that confuse people drastically, we can plot the Greeks on charts. We can also plot IV on charts, which is a way to analyze options potential. There are many platforms out there that chart the IV for traders. One of the most well known and popular charts for IV is the VIX (CBOE Volatility Index). This shows traders the values of near-dated and near the money S&P 500 index options. Any stock that is optionable can have its own version of the VIX.
Below is a chart of the VIX you can see what the average level is around 20 or so, and what the low and high ends of the band are. It’s difficult to predict how volatility will move, and when. But there are multiple ways to gather information from this chart. One is to notice the extended peaks that do not last a long time and understand that the rise in IV means an increase in uncertainty. Meaning there is the potential for a downside move in the S&P 500. The other way to look at the chart is to identify the highs and lows of the oscillations. Staying at lows for too long will cause a pop in IV and uncertainty in the S&P. To the opposite end popping too aggressive cannot stay strong for long and we can see a drop in IV. However, there is no set way to identify when a pop will happen from lows. VIX lows are the norm because markets are perpetually long.
Implied Volatility Options Strategies
Traders love identifying trade opportunities and strategies based on implied volatility spikes or drops. If you understand how implied volatility works, and how to forecast implied volatility you will make the process of buying cheap options and selling expensive options easier.
Take earnings, for example, this is one of the easiest ways to identify spikes in IV. Earnings season comes once a quarter and uncertainty build. Uncertainty is IV’s twin sibling. Where there’s one there’s the other and fear starts to mount.
Leading up to earnings, the 2 weeks prior we see a stock increase in uncertainty even if the underlying price doesn’t change. That means that implied volatility increases. The uncertainty comes from not knowing if earnings will beat or miss. With the options of even showing up as expected. Whatever the case the IV of a stock usually sees a spike until the day before or the day of earnings when the uncertainty is muffled by the new release.
That means when you expect a stock’s earnings to come out, traders look for low costing options that are expected to increase in value leading up to the uncertain report. But there’s one issue, will the price of the underlying go up or down? You won’t really know. And you don’t want to speculate into earnings picking a direction. So you look for a non-directional options strategy. That’s where the straddle comes into play. The long call and long put to take advantage of the increase in IV on both ends. A directional move prior to earnings is the icing on the cake.
When it comes to selecting an options strike, expiration, and strategy you should consider the effects of IV on the price of the option which will enable you to make a better decision. There are a lot of tools for options in select platforms like Interactive Brokers. This knowledge will help you identify if options are overpriced or underpriced. If you want to learn more about equity futures like Nasdaq and day trading based on price action, check out TRADEPRO Academy’s Elite Course (Click the button below).
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.