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What You Should Know About Stock Options Implied Volatility

Stock options implied volatility is one of those terms you so often hear, but understanding its significance can be critical to a successful trading outcome. In fact, some traders believe in it so much that they are known as “volatility traders”. Directional trading (predicting the future direction of the underlying) is difficult enough as it is, so anything that allows you to stack the odds in your favour has got to be worth investigating. Factoring implied volatility into your trading decisions achieves just that.

Stock options implied volatility (IV) is a number which expresses the anticipated future price volatility of the underlying financial asset in terms of the current market price of the option. If the IV, expressed as a percentage, is high, then this theoretically reflects a large anticipated average price change in the underlying within the timeframe covered by the number of days to option expiration date. If it is low, then it implies that the stock price is not expected to move much in the future – theoretically.

The implied volatility is calculated using option pricing models. These give a theoretical value of an option contract based on the current market price of the underlying relative to the option strike price and remaining time to expiration. But since options markets have their own supply and demand, market forces come into play and create inflated or deflated options prices due to interest in the options or lack thereof. For example, during times of uncertainty when the market is expected to dive, put options are high in demand as investors rush to hedge their positions, which in turn drives their prices up.

But this is not always the case – and herein lies opportunities for the trader.

Using Stock Options Implied Volatility to Your Advantage

Here are a number of ways that traders, using varying trading strategies, can take advantage of Implied Volatility.

1. Straddle or strangle traders should look for low option IV when entering positions. This quite common near the end of chart triangle patterns, which often precede a price breakout. Low IV means the options will be cheap, but once the price action begins to explode, the IV of either calls or puts should increase due to popular demand. The inflated options prices on one side will more than pay for the losing options (bought cheaply) on the other side and yield a profit.

2. Option spread traders should consider IV when looking at each leg of their positions. If you’re executing a credit spread or an iron condor, it is desirable to sell the short options with a higher IV than the further out-of-the-money options you will buy. Alternatively, a debit spread trader should look for the reverse, because in the event of the stock price going against you, it will provide a buffer before your stop loss is hit.

3. The Victory Spreads strategy comes alive when finding securities where there is an implied volatility skew. When you find them, these types of trades are “set and forget” positions where it’s almost impossible to lose.

4. Calendar Spread traders should ensure that the IV in the back month is not more than 2 percent greater than the IV in the front month options that you’re going to sell.

Stock Options Implied Volatility and the $VIX

If you’re trading stocks and options on US markets, you should always be aware of the $VIX or Volatility Index. It should not be confused with the implied volatility in option prices though, but is nevertheless very useful. It works in a way that is opposite to the Dow Jones Index, in that it goes up when the Dow is going down, and vice versa. The reason for this, is that the $VIX measures the overall market ratio of put options that are being traded, in contrast to call options. Since the market buys more puts to hedge positions when prices are falling, the $VIX will rise accordingly.

The Volatility Index can be used as a barometer for future overall market direction. When it reaches extreme levels or strong resistance points, it indicates the US market price action may be due for a reversal.

Volatility Skews

Volatility Skews occur when there is an unusual IV difference between at-the-money, out-of-the-money and in-the-money options prices for the same security. Some options prices become unusually affected when demand for them is greater than for their counterparts at different strike prices. Consequently, they become over-priced and this creates the volatility skew. When this occurs, it can present opportunities for option spread traders or those wishing to use short positions.

Stock Options Implied Volatility – How to Tell When it is High or Low

It’s easy to say that the IV in an option price is “high” or “low” but how do you know this? One obvious way, is to compare it with other option IV’s for different strike prices or expiration months. Another way, is to know what the historical volatility (HV) for the underlying security (not the options) is and compare it with that. Most online broker websites should be able to provide this information. It is the average price range of a stock over a given period of time, expressed as a percentage.

If your options strategy is to simply go long calls or puts, you should look to see whether the IV in the options prices you’re thinking of buying is the same or lower than the HV for the stock. If not, then your options may be over-priced and in the event of a move in your favour, may not realize the profit levels you were hoping for. Sometimes the underlying security can move as you expected but if you’ve bought over-priced options, you don’t make any money.

When working out your trading plan, don’t forget the advantages of stock options implied volatility!

The appealing thing about option straddles is that they’re non-directional. This means that you can make money without forecasting market direction. In other words, it doesn’t matter whether the stock price goes up or down in the near future – you can still make money either way – as long as it moves somewhere.

The idea behind a straddle is that you simultaneously purchase the same number of call and put options, with the same expiration date. The plan is, that thanks to option implied volatility and “the delta”, the profit from the winning option will more than compensate for the loss on the losing one, with a good profit remaining.

What to Look for With Option Straddles

Option straddles are a “slow-moving” trade that can take anywhere from a few days up to a month to do its thing. It works best on stocks that are in a period of price consolidation with the expectation that a breakout may be coming soon.

If you are a technical trader, one of the best chart patterns I have found for straddle trade setups, are what is commonly known as “triangle” or “wedge” formations. With the triangle pattern, this is where the recent highs and lows of the daily bar charts are coming together. In other words, the highs are getting lower while the lows are getting higher so that if you draw a trendline over the highs and lows, you’ll see them converging into a point.

You want to trade option straddles as near as possible to the convergence of the two trendlines. Even at the breakout moment is good. The best straddle breakouts come after you see this pattern forming for about 3 months. Anything shorter than that may result in a breakout that doesn’t have sufficient momentum to give you the maximum profit.

Another vital thing when buying option straddles is that you need to ensure that the options you buy have at least 90 days to expiration. If you do this during a period of price consolidation, such as in the triangle pattern above, the option prices are likely to be the cheapest around that time, due to low price volatility. This is ideal for straddle trades.

The downside of option straddles is that they cost more to enter than other trading strategies such as spreads. Nevertheless, in the US markets where option contracts only cover 100 shares, they are still quite affordable. If cost is a barrier to you, you might like to consider an alternative strategy called Victory Spreads. A double Victory Spread – done with both calls and puts, achieves exactly the same result as the options straddle but only risking a pittance by comparison.

You also want to avoid stocks that are historically slow-moving, because the whole idea behind a straddle is to anticipate a short-term price breakout that moves far enough before the option expiration date, to give you a net profit.

Another indicator that a price breakout could be imminent, is an upcoming earnings report, say, in about 3 weeks. Alternatively, a large movement in the overall market can also affect individual stocks.

Coming back to “triangle” patterns, there are three main types. Where the highs and lows are converging, this is called a “symmetrical triangle”. However, you often see the lows getting higher, but the highs being equal because they are hitting a resistance level. This is called an “ascending triangle”. The reverse of this is the third type, namely, descending triangles. These are ideal conditions to implement a straddle strategy.

The final thing you want to check before placing your order for option straddles, is the “implied volatility” in the option prices, compared to the “historical volatility” of the stock price. Ideally, the former should be lower than the latter. Any decent options broker will be able to provide this information.

Finding Triangle Patterns – The Easy and the Hard Way

Wading through a long list of stock charts to try and find triangle patterns can be a very tedious process. But if you have the software or a broker service that allows stock scanning, you can make the process much quicker.

Here’s what you can do.

There is an indicator known as the ADX, or “Average Directional Index”. It is usually used in conjunction with the +DMI and -DMI indicators, but for our purpose, we can ignore these. The general rule is, that when the ADX crosses above 15 the market is likely to break out. Below 15 the market is consolidating.

So if you have a scanning facility, you would set your stock price filter to between $20 and $10k and your ADX filter to crossing above 15. It will produce a list of stocks that qualify for both parameters.

Option Straddles Summary

Straddles are one of the safest and most stable option trading strategies available because you’ve eliminated the need to predict market direction. It does have some risk, namely, that the stock goes nowhere, in which case, time decay on your bought positions will work against you. But if you’ve purchased when the volatility is low and the price is cheap, your losses will be minimal. Straddle profits are theoretically unlimited, but anywhere between 20 – 50 percent per trade is quite easily attainable.

Straddle Payoff Diagram

There is an alternative that works exactly like the straddle but with this difference – the amount you lose if the stock goes nowhere is much less. They’re also more flexible, cheaper to put on and carry less risk.

They are called Victory Spreads

Enjoy This Video Presentation on Straddle Options Strategies

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