implied volatility options trading

How Implied Volatility Can Effect the Success of Your Options Trades

Trading stocks is fairly straightforward. If you buy the stock and the price rises, you make the difference between the current price and your cost. If the price drops, you lose the difference between your cost and the current price. It doesn’t matter how long you hold the stock or what else happens in the market, even if it’s related to the stock. All that matters to your profit or loss is the price you bought and sold the stock at.

Trading options is much more complex, because there are numerous factors that play a role in effecting the options pricing. The factor that we’ll discuss in this post is implied volatility.

Implied volatility reflects the market’s perception of uncertainty about the future movement of the underlying asset. Higher implied volatility indicates greater uncertainty, which makes option prices more expensive. That’s because the people writing, or selling, the options are taking on more risk, so they raise the options premiums to cover that added risk.

Higher implied volatility generally leads to higher option premiums, and lower implied volatility leads to lower premiums.

Higher implied volatility also increases the potential for larger price swings in the underlying asset, which can result in greater profits or losses for option holders. That potential for large price swings causes the premiums to be more expensive.

It’s not clear who exactly determines the implied volatility on a financial instrument. Most likely it’s the market makers of that instrument. But it doesn’t really matter who determines it — all that matters to traders is that it exists.

Let’s look at a fictional example:

Suppose there is a stock trading at $100 per share, and you are interested in buying a call option with a strike price of $105 that expires in one month. At the current implied volatility, the option is priced at $3.

Now, imagine there is a significant news event expected to be announced in a few days that could potentially impact the stock, like an earnings release or investor presentation. This creates uncertainty in the market, leading to an increase in implied volatility.

As a result of the increased implied volatility, the option price may rise even if the stock price remains at $100. The higher implied volatility reflects the market’s anticipation of increased price swings in the stock in response to the upcoming news. Due to the higher implied volatility, the option price might increase to $5, even though the stock price remains unchanged.

Conversely, if the implied volatility decreases, the option price could decrease even if the stock price remains the same. For example, once the earnings are released, the implied volatility that rose ahead of the release will usually drop significantly (IV crush).  In this case, the option price might drop to $2, causing you to lose money while the stock price holds steady.

This inevitable implied volatility contraction following an anticipated, potentially market moving, event is a major reason for not holding options through the respective event. Even if the event goes according to what you anticipated, you can still lose money if the underlying stock doesn’t move enough to compensate for effect of the implied volatility drop on the price.

Long Term Positions

Changes in implied volatility will have the most pronounced effect on shorter dated options. The further the expiration dates are on your options, the less implied volatility will effect the option price, assuming that the underlying instrument price moves materially in your direction.

For example, if a company has an earnings release in a few days and you buy a call with an expiration date 3 months in the future, the implied volatility drop from the ER should be minimal — but it’s hard to calculate with any certainty since the determination of implied volatility is pretty much a black box — for market maker eye’s only.

Intraday Changes in Implied Volatility

Material changes in implied volatility don’t only result from major events such as earnings releases. They could happen during a regular trading session as a result of a news release or rumor that causes a surge of trading activity. If you get into an options position at the start of one of these surges, you can often get out at a nice profit based on the IV boost alone. On the flip side, if you buy in at the apex of the IV surge, you can lose quickly when the excitement calms and the IV drops, even if the underlying price remains relatively unchanged.

Bottom Line

When trading options, just getting the direction of the underlying move is not enough to assure a profit. You also need to take into account the effect that a change in implied volatile will have on price of your option.

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