Using implied volatility in options trading is just as important as using it in stock trading. The more volatile a stock, the better its chance to make a tradable move.
If you have a bad impression of volatility, it’s time to unlearn it. Options trading is counterintuitive to the way so many of us were raised…
The old idea that “time in the market beats timing the market” doesn’t apply to smart options trading. If you have no idea what I’m talking about — read on to skill up!
Table of Contents
- 1 What Is Implied Volatility?
- 2 How Does Implied Volatility Work?
- 3 How Implied Volatility Affects Options
- 4 How to Use Implied Volatility to Your Advantage
- 5 Implied Volatility Vs Realized Volatility
- 6 Final Thoughts
What Is Implied Volatility?
Implied volatility (IV) is the estimate of a stock’s future volatility over a period of time. The more volatile a stock, the faster its price moves.
Some options traders base their entire strategies around IV. Volatility is a great way to generate the price swings necessary for an option’s underlying asset to hit its strike price.
How Does Implied Volatility Work?
Implied volatility works by predicting the speed of price changes. The IV of options is determined by trader consensus.
This consensus is influenced by how market participants view an asset’s past volatility, and its future potential to increase or decrease this volatility.
How Implied Volatility Affects Options
Here are some examples of how IV affects options contracts:
- IV affects the pricing of options. High-IV options are usually in more demand, so they have higher prices. On the flip side, options with low IV usually have lower prices.
- IV isn’t static — it can change as time passes. This can also affect the option’s value.
- Expiration dates influence how much an option is affected by IV changes. Options that expire sooner respond less to IV changes, and vice versa for later expiration dates.
- Strike prices also influence an option’s reaction to IV changes. Near-the-money options respond more to IV changes. In-the-money and out-of-the-money options are less sensitive.
How to Use Implied Volatility to Your Advantage
Using implied volatility to your advantage is key to many options strategies. Using top-notch charting software like StocksToTrade can be a powerful tool.
Charting an option’s past volatility can help you predict future IV. Like many things in the market, IV is cyclical. Low-volatility periods are followed by high-volatility periods. Understanding this cycle helps you make informed trading decisions.
Here are three strategies you can try to take advantage of IV:
Strategy 1: Buy the Rumor, Sell the News
“Buy the rumor, sell the news” is common advice in trading. Stock prices can change in advance of events like a product launch or earnings reports. Options prices can fluctuate in a corresponding way.
After the news comes out, it’s anybody’s guess. Prices can continue trending in the same direction, or reverse course.
Why We Like It
If you have access to a powerful news scanner like the one in StocksToTrade, you can sniff out rumors before they impact price too much. You might be able to trade an option on the rumored asset before the new development is priced in.
Strategy 2: Selling Strategies for High Implied Volatility
Options with high IV are usually expensive. When option premiums are expensive, the advantages of writing instead of buying them increase.
You can also consider advanced strategies like credit spreads, naked puts, and covered calls.
Why We Like It
Being an option writer gives you another way to profit off high IV. Just be careful — selling options can get very risky!
For traders who know what they’re doing, selling options can be a valuable tool in a profitable overall strategy.
Strategy 3: Buying Strategies for Low Implied Volatility
When IV is low, some traders stock up on options contracts with far-off expirations. The idea is to hold these options with the hope that their volatility increases and they become more valuable.
I’m no fan of the hold and hope mindset…
Remember this chart well, its the basis for my 7-step framework, @30DayBoot & @completepenny & you must study not to fall prey to greed/ignorance or you'll get wrecked like 90% of traders. It's VITAL to sell into excessive strength/hype, do not just hold & hope like most newbies pic.twitter.com/QsAGHsI6lp
But low-IV options contracts aren’t penny stocks. Some options traders are big fans of this approach!
Buying calls and puts, long straddles, and debit spreads are some of the strategies that can be employed here.
Why We Like It
Selling options contracts — instead of executing them — is one way this basket of strategies can become profitable.
I’m a big fan of flexibility in trading… You have to adapt to the market, not the other way around.
Implied Volatility Vs Realized Volatility
Implied volatility and realized volatility (or historical volatility) measure the same thing — a stock’s price action. How do the two differ?
- Implied volatility is calculated based on supply, demand, and market expectations. It measures future volatility, which is one of the main indicators for determining an option’s execution potential.
- Realized volatility measures past price action. Historical volatility can inform IV because of its cyclical nature.
Both volatility measures are important when trading options.
Implied volatility estimates future stock price movements. You can use it to predict whether the option will hit its strike price.
But you’re not the first one who’s made this connection. And until you can incorporate this knowledge into your trading strategy, you’ll be at a disadvantage on the trading battlefield.
Learning from experienced traders is one of the best ways to catch up with the rest of the market.
If you’re searching for a mentorship program, check out my former student Mark Croock’s Evolved Trader. He’s taken my penny stock strategies and applied them to options trading — making $3.9 million in career earnings in the process!
Here’s a sneak peek of Mark’s curriculum: