High Implied Volatility for more Options Profit
Before explaining high Implied volatility we look first what Implied Volatility (IV) is. IV is one of the most important metrics to understand when trading options. Implied volatility is the estimated volatility, of a stocks price.
Implied volatility increases while the market is uncertain about the changes in the stock or sector market, about earnings, companies decisions, or if people are bearish. The market is bearish when investors believe the asset’s price will decline over time. And IV decreases when the market is bullish. This happens when investors believe that the price will rise over time. This is due to the common belief that bearish markets are riskier than bullish markets.
Implied volatility is a way of estimating the future fluctuations of a security’s worth based on certain predictive factors. 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 standard deviation range for the stock based on the option prices. For example, an IV of 20% on a $100 stock would represent a one standard deviation range of $40 over the next year.
High Implied Volatility
There are many ways why options have high IV. People may be uncertain of the market, they do not know whether the company that introduces a new product or service is what people hoped for, earnings announcements or several other reasons. The fact is that it drives the price of the option.
What does “one standard deviation” mean?
In statistics, one standard deviation or 1 SD is a measurement that encompasses approximately 68.2% of the outcomes. When it comes to IV, one standard deviation means that there is approximately a 68% probability of a stock settling within the expected range as determined by option prices. In the example of a $100 stock with an IV of 20%, it would mean that there is an implied 68% probability that the stock is between $80 and $120 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 increases 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.
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. We sell option premium when Options Implied Volatility is high. IV is high because of uncertainty in a country, a sector, or on a company. Usually options does not have long high IV. IV drops to the mean when fear diminishes. This edge we use to sell options and receive option premium. And manage the trade by buying the option back as soon as fear diminishes.