The best options trading strategy is to sell option premium (although it's important to buy options occasionally too).
But, how do you know whether you're receiving a good price? Implied volatility is one component of the option price.
David Jaffee of BestStockStrategy.com encourages his students to act like an insurance company, collecting option premium by selling options.
This options strategy minimizes risk while maximizing the probability of profit, helping traders earn a consistent income.
If you are new to writing options, you may not know where to start.
Keep reading to learn about implied volatility, including how implied volatility affects options trading.
High vs Low Implied Volatility
Implied volatility serves as a forecast of the market’s view on how likely a given security’s price is to change.
Investors often used implied volatility to predict the future price fluctuations of a security, and implied volatility is sometimes a proxy of market risk.
High implied volatility indicates that a large price swing is expected. Low implied volatility indicates that a large and unpredictable price change is not expected.
Implied volatility only represents the probability of a price change, not the direction the price will move (although, in general, when volatility is high then traders and investors are expecting potential downside risk).
For example, if a security has a high implied volatility, the price can swing up very high or down very low.
In bearish markets, implied volatility tends to increase due to increased risk. In bullish markets, you can expect implied volatility to decrease.
To become a profitable trader, it is important to understand the impact of implied volatility.
Using Implied Volatility for Options
So how does implied volatility impact options traders?
If you want to earn a consistent income by selling option premium, implied volatility can be used as a factor when calculating options prices.
Implied volatility can be used to approximate an option’s future value. If implied volatility is high, the option premium will be higher. If the implied volatility is low, the premium will be lower.
However, implied volatility is not a guarantee when it comes to options trading.
Based on probability, implied volatility does not ensure that the price of an option will follow the pattern that has been predicted.
Instead, implied volatility correlates more directly with market opinion, which can affect option pricing.
Implied volatility can also be influenced by unexpected factors, making traders vulnerable to undesirable changes.
It's best to sell options when implied volatility is high.
Usually, the expected (or implied) volatility is more than the actual volatility.
This is one reason why selling option premium is a good strategy.
However, when implied volatility, as measured by Implied Volatility Rank (“IVR”) or the VIX (a measure of the volatility on the S&P 500), is low then it's usually best for option sellers to use a vertical credit spread trade structure because it protects them against a large volatility expansion event.
During periods of low VIX, it's also a good idea to BUY OPTIONS to reduce future portfolio volatility.
How is implied volatility calculated?
Option pricing models can be used to determine the implied volatility of an option, including the Black-Scholes Model and the Binomial Model.
While the Black-Scholes Model is quicker, it is not as accurate for American options trading.
Binomial Model considers the possibility of early exercise, making it more applicable to options trading in the U.S.
Calculations for the Binomial Model take longer because the tree diagram shows all possible paths of the price of an option at each level. By working backwards, you can determine a single price.
Many of the stock trading platforms and online stock brokerages available today offer some implied volatility tool.
These tools may come in the form of stock indicators or information, but they only offer the basics.
As you become more refined in your options trading strategy, it may become to learn how to calculate implied volatility for yourself.
What affects implied volatility?
Why do some options have high implied volatility while others have low implied volatility?
There are several factors that impact implied volatility and an option’s premium, including supply and demand and time until expiration.
Learning the factors that affect implied volatility can help you become successful at trading options.
- Higher demand leads to higher prices, higher implied volatility, and higher premiums
- Greater supply and less demand leads to lower implied volatility and a cheaper option price
- Short-dated options have lower implied volatility
- Long-dated options have higher implied volatility
Implied Volatility Trading Strategies
When using implied volatility to price options, there are some key considerations to keep in mind.
- Implied volatility indicates market sentiment and the size and magnitude of the move an asset may make.
- Implied volatility does not indicate the direction of the movement an asset may take.
- Implied volatility can be used by option writers to help price options contacts.
- Investors often use implied volatility when choosing an investment.
Use Implied Volatility for Your Benefit
David Jaffee has found that tools like IV Rank from Tastytrade do not help traders make money.
Instead of relying on shortcuts that may not work, you can learn the best options trading strategy.
Implied volatility may seem like a complicated concept, but David Jaffee provides a comprehensive options trading course that is beneficial for all skill levels.
Learn how to sell option premium and earn a profit by signing up at BestStockStrategy.com today.
While definitions, education and learning about trade structures are important, will it help you make money?
BestStockStrategy.com teaches the best strategy where disciplined traders can win up to 98% of their trades.
Our products are extremely efficient and enable you to learn only what is necessary - that way you can practice and become an expert on the most important tactics, tips and strategies that will yield the highest returns for stock market traders.
Our goal, at BestStockStrategy.com, is to provide the most efficient and simplest way for traders to be successful.
As a result, I highly encourage you to enroll in the 7 day trial of the trade alerts and option trade signals at https://beststockstrategy.com/memberships
Or, if you want the fastest and easiest way to learn how to trade options, then it's best to enroll in the Options Education Course, which is a comprehensive course of 12 lessons that teaches you everything you need to know.
Frequently Asked Questions (FAQs)
What is implied volatility?
Implied volatility is the market's forecast of a likely movement in a security's price. It is a metric used by investors to estimate future fluctuations (volatility) of a security's price based on certain predictive factors.
Why is implied volatility important?
Future volatility is one of the inputs needed for options pricing models. The future, however, is unknown. The actual volatility levels revealed by options prices are therefore the market's best estimate of those assumptions. If somebody has a different view on future volatility relative to the implied volatility in the market, they can buy options (if they think future volatility will be higher) or sell options (if it will be lower).
How is implied volatility calculated?
Since implied volatility is embedded in an option's price, one needs to re-arrange an options pricing model formula to solve for volatility instead of the price (since the current price is known in the market).
What does implied volatility tell you?
Implied volatility represents the expected volatility of a stock over the life of the option. As expectations change, option premiums react appropriately. Implied volatility is directly influenced by the supply and demand of the underlying options and by the market's expectation of the share price's direction.
Is implied volatility good or bad?
When implied volatility increases after a trade has been placed, it's good for the option owner and bad for the option seller. Conversely, if implied volatility decreases after your trade is placed, the price of options usually decreases.
Is high IV good for a stock?
Implied volatility is derived from options prices, so changes in options prices affect IV. High IV environments allow traders to collect more premium, or move strikes further away from the stock price and still collect a decent premium for short options strategies.