Implied volatility as a trading tool

Implied volatility as a trading tool

Implied Volatility is important when you are selling options. It is a great trading tool that shows you how much potential the stock can move according the market’s opinion. It doesn’t give a clue which direction it is going to move though. If implied volatility is high, the market expects that the stock can move largely. When the stock has low IV it implies that the stock will not move much.

For successful option traders e.g. for people who are selling option premium Implied Volatility (IV) is very important. It is more important than historical volatility. The reason for this is that IV includes all market expectations. If, for example, the company plans to announce earnings or expects a major court ruling, these events will affect the implied volatility of options that expire that same month.  Implied volatility helps you gauge how much of an impact news may have on the underlying stock.

 

Implied Volatility the trading tool

How can option traders use IV as a trading tool to make more informed trading decisions? Implied volatility offers an objective way to select your option strikes. With an option’s IV, you can calculate an stock option’s expected lowest and highest price. Implied volatility helps you measure a trade’s risk and potential reward.

Since most option trading volume usually occurs in at-the-money (ATM) options, these are the contracts generally used to calculate IV. Once we know the price of the ATM options, we can use an options pricing model and a little algebra to solve for the implied volatility.

Implied Volatility rise

Use Mean Reversion to predict direction

Implied Volatility as a trading tool to determine the rise in IV and and stock option prices are high when a stock moves a lot. After a big move we expect that the option price will drop and eventually move back towards the mean or average. This mean or average can be the historical average of the price or another relevant average such as the growth in the economy.This theory has led to many investing strategies involving the purchase or sale of stock options whose recent performance has greatly differed from their historical averages. We like to be contrarian. Not trading with the trend. Sell into strength and buy into weakness is the new philosophy. So, after a big move up we might sell a call option, and with a big down move we might sell a put option to profit from volatility contraction.

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