The Unlucky Investor's Guide to Options Trading guides readers through the world of options and teaches the crucial risk management techniques for sustainable investing.
What Is Implied Volatility?
Implied volatility (IV) in the stock market refers to the implied magnitude, or one standard deviation range, of potential movement away from the stock price in a year's time.
A low implied volatility environment tells us that the market is not expecting the stock price to move much from the current stock price over the course of a year. A high implied volatility environment tells us that the market is expecting large movements from the current stock price over the course of the next twelve months.
Implied volatility is presented on a percentage basis and can be altered based on the timeframe you’re actually looking at trading, since we are typically trading in a more near-term duration than 365 days. The tastyworks platform makes this easy for us to see. The +- number is the expected move of the stock price given the current implied volatility percentage, adjusted for the timeframe of the expiration:
In the SPY example below, we see that over the next 44 days in the January monthly cycle, the market is expecting a 21.0% implied volatility, which translates to an implied $19.53 range above or below the current stock price of $470. In other words, the current implied volatility and timeframe implies a $39.06 potential range from the current stock price, or between $450.47 and $489.53.
Over the course of 373 days, the implied volatility is 26.9%, which implies a move of +- $73.52 above or below the current stock price of $470, that’s a range of $147.04, or between $396.48-$543.52.
How Is Implied Volatility Calculated?
Implied volatility is derived from the Black-Scholes model, and it is required to have all other inputs (stock price, expiration, etc) to solve for IV%. One of the common misconceptions is that implied volatility drives options prices, but it’s actually the other way around; changes in options prices allows us to find a new value for IV after the change has already happened.
The Black-Scholes model is complex, and most trading platforms will offer IV% values and possibly expected move values as well, like the tastyworks platform image above, but the most important thing to understand is that option prices drive changes in IV%, not the other way around.
How is IV Used in Options Trading?
Implied volatility is a measure of perceived volatility, so it is important to keep an eye on it so that we know what kind of product we are trading from the start.
High IV products tend to move around a lot, even if it’s not in just one direction, so it may be a situation to avoid for more conservative or risk averse investors.
Conversely, high IV products offer higher extrinsic value premiums than low IV products, which is why short premium options traders are drawn to it. Low IV environments equate to “cheaper” options due to a lack of extrinsic value, and high IV environments equate to “expensive” options due to the abundance of extrinsic value.
How to Find Implied Movement of a Stock for Different Expirations
Finding the implied volatility of a stock for different expirations can be tough with the complexity of the Black-Scholes model, and these implied ranges are based on annual expected moves by default.
At tastytrade, we use the expected move formula, which allows us to calculate the one standard deviation range of a stock based on the days-to-expiration (DTE) of our option contract, the stock price, and the implied volatility of a stock:
For example, the 1SD expected move of a $100 stock with an IV% of 20% is between +- $20 of the current stock price, or a range between $80 and $120.
Before diving into how this impacts options trading practically speaking, it’s important to understand the probabilities associated with certain multiples of standard deviations:
Standard Deviation Bell Curve
1, 2, and 3 Standard Deviation Moves
One standard deviation of a stock encompasses approximately 68.2% of outcomes in a distribution of occurrences based on current implied volatility.
Two standard deviations of a stock encompasses approximately 95.4% of outcomes in a distribution of occurrences based on current implied volatility.
Three standard deviations of a stock encompasses approximately 99.7% of outcomes in a distribution of occurrences based on current implied volatility.
Think of any stock you like, and consider tracking how many times in a row it goes up in price, or down in price, for consecutive days. Over a large window of time, you’ll see that the vast majority of stock price movement would land in the one standard deviation range of outcomes.
This may be something like 1-3 days in a row moving in the same direction. Going out to 2 standard deviations would certainly have less occurrences, and would track something like 4-7 days in a row moving in the same direction. 3 standard deviations would encompass the fewest occurrences of 7+ days in a row moving in the same direction.
As you can see, the highest number of occurrences will generally encompass what we expect and the lowest number of occurrences will encompass outlier events.
How to use IV to Your Advantage in Options Trading
One cool thing about the standard deviation of a stock & implied volatility is that when IV is high, we can obtain these one standard deviation probabilities using much wider strikes.
In the example above, let’s say I want to sell a put at the 95 strike with XYZ stock trading at $100. If implied volatility is high, the strike may be worth $7.00, where my max profit is $700 if the strike expires OTM, and if it goes ITM, I can use that $7.00 in premium to reduce my breakeven to $88 if I took the shares.
In a low IV environment, the same strike might only be trading for $3.50, which is half the extrinsic value compared to the high IV environment. This means half the max profit, and half the breakeven reduction against the strike if I were to be assigned the shares (breakeven of $91.50).
Let’s take a look at another example that shows the difference between a high and low IV environment below:
In the above example, let’s say I’m just looking to collect $3.50 in extrinsic value premium for selling a put, and I want to take the stock if the put goes ITM. In a high IV environment, I may be able to go to the $90 strike to collect that $3.50, and my breakeven would be at $86.50 if I took the shares.
In a low IV environment, maybe I’m at the $95 strike to collect that same $3.50 in premium. That means my breakeven for the shares would be $91.50, a full 5 points higher than the high IV environment’s strike.
That’s the power of high implied volatility, and how it affects our trade entry price, and proximity from the stock price.
As you can see, understanding what implied volatility is telling you about a stock’s expected future movements is very valuable, and can change our options trading strategy altogether depending on how high or low IV is. It can greatly impact our strike choices, breakeven prices, and max profit implications.
Implied Volatility FAQs
Implied volatility being high or low is dependent on the product itself. For example, ETFs typically have lower implied volatility than single name equity products, because equities have a lot more implied movement due to binary events like earnings announcements. To see if IV is high or low for a particular product, we use contextual metrics like IV Rank or IV Percentile, which helps us see how current IV compares to an annual historical range.
Low implied volatility for a specific product depends on where the historical range has been, and we can use IV Rank or IV Percentile to get a better gauge on the product we’re trading Generally speaking though, IV% in the teens for ETFs is relatively low, and the 20-30% range for equities is relatively low, depending on the product.
Implied volatility is the annual implied movement of a stock, presented on a one standard deviation basis. If XYZ stock has an implied volatility of 20% and it is currently trading at $100 per share, the market is expecting to see it move between a range of $80-120 over the course of a year, with a 68.2% probability of accuracy.
Implied volatility is derived from the Black-Scholes Model by entering all other inputs and attempting to solve for IV by using options prices. One of the most common misconceptions is that IV drives options prices, but it is actually the other way around!
Implied volatility is the perceived movement of a stock price derived from the options market of that particular stock.
If a stock has an implied volatility of 100%, that means over the course of a year, the stock is projected to double in price or go to zero. These products typically have very high extrinsic value in the options market, and fly around like crazy. Not for the faint of heart!
Implied volatility is presented on a percentage basis, so that you can quickly determine what that means for the stock you’re looking at. It gives implied volatility a more universal feel so you can see what products are projected to move a lot, or not move a lot at all.
Implied volatility is derived from options prices, so changes in options prices affects IV!
If implied volatility is high, that means the expectation is high that the stock price could move around a lot. Higher IV means wider expected ranges from the stock price, which means delta values are spread out much more than a low IV environment. Think of a low IV environment like a narrow steep bell curve, where deltas drop off significantly and quickly as you move away from the stock price. Think of a high IV environment like a more flat, wide net where deltas are spread out much more evenly as you move away from the stock price. OTM option deltas will be higher if you go 10 points away from the stock price in a high IV environment compared to a low IV environment.
Implied volatility is good for short premium trade setups, in the sense that you can collect more extrinsic value premium for taking the same notional value risk as a low IV environment, where you’d get paid less. You can create much more favorable breakeven prices in a high IV environment with this excess extrinsic value, but that also comes with more implied movement in the stock price. Implied volatility being high means a more expensive option for buyers.
Most trading platforms offer IV% values on the platform itself when you are looking at the options chain of an underlying. The tastyworks platform offers this, and the expected move as well!
Some trading platforms offer implied volatility of options strikes themselves - tastyworks is one of those platforms! You can see the implied volatility of an option by changing one of the columns on the trade page to “Imp Vol”
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