IV expansion or contraction refers to implied volatility reverting to the mean. When IV is high, we can expect an IV contraction. When IV is low, we can expect an expansion. The unknown factor in both of these scenarios is timeframe. IV reversion is recognized within the derivatives market, which is why we base all of our trades around IV expansions and contractions.
Implied volatility and option prices have a positive correlation. When IV expands, option prices increase, and when IV contracts, option prices decrease. This is because higher IV suggests a larger expected range of stock prices in the future, while lower IV suggests a smaller expected range for the stock prices.
When buying and selling premium, we can experience profit from the expansion or contraction in IV with no change in the stock price. Looking at IV rank is a best practice of ours because it provides context to a specific underlying’s IV. This helps us decide whether to use a credit or debit strategy.
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