Advantages by Trading Implied Volatility

Implied Volatility TradingTrading Implied Volatility is selling the premium of the volatility expectation that is priced into individual options. The implied volatility of an option is actually backed out of the price of the option. All the inputs of an options pricing model are known (time to expiration, strike, price, interest rates) except for the volatility that the option is pricing in. So that value can be backed out and allows the traders to understand the relative value of the option’s price. Is a $1 call cheap or expensive? Looking at the implied volatility allows you to get an idea of its relative value.

Trading Implied Volatility

Volatility, of course, is a measure of uncertainty. A high-volatility stock has a greater potential range than a low-volatility stock. But when we talk about the above types of volatility, the measure is a statistical formula that determines the one standard deviation annual distribution.

Example: If we have a stock trading at $100 with an implied volatility of 25 percent, the options are implying that the stock will be higher or lower by 25 percent within one standard deviation. (One standard deviation equals 68 percent in a normal distribution.) So the stock has a 68 percent probability of being between $75 and $125.

Trading Implied Volatility

While the volatility data that we usually look at is an annual figure, you can also get monthly or daily numbers. The daily data can be obtained by dividing the volatility figure by the square root of the number of trading days in a year, which is usually accepted as 252. So if the volatility is 32 percent, the daily moves should be 2 percent (32 divided by the square root of 252, or approximately 16). That means that 68 percent of the time the daily moves should be 2 percent or less.

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How to Use Implied Volatility to Your Advantage
One effective way to analyse implied volatility is to examine a chart. Many charting platforms provide ways to chart an underlying option’s average implied volatility, in which multiple implied volatility values are tallied up and averaged together. Professionals use the Think or Swim platform, I like the Dough platform very much.

On these platforms you can easily see what the implied volatility rank is from these options. When IVR is high you have an excellent candidate of Trading implied volatility.
When you see options trading with high implied volatility levels, consider selling strategies. As option premiums become relatively expensive, they are less attractive to purchase and more desirable to sell. Such strategies include covered calls, naked puts, short strangles, short straddles Jade Lizards and credit spreads.
The Bottom Line
In the process of selecting strategies, expiration months or strike price, you should gauge the impact that implied volatility has on these trading decisions to make better choices.

Read more: investopedia