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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 Option Strangle – A Cheaper Alternative to the Straddle

The Option Strangle is an option trading strategy which relies on three important prerequisites:

That the investor has no particular opinion as to the short term future direction of the underlying stock or commodity, and
That the future short term direction of the underlying stock is expected to be volatile – i.e. it is anticipated that it will move strongly in one direction before the options expire. Finally,
That the options you are considering purchasing are relatively cheap.

The first two of the above three criteria are absolutely essential for an option strangle trade to be successful. The third criteria is almost as important.

The option strangle is a cheaper alternative to the straddle. It involves purchasing an equal number of call and put options, usually with an expiry date of at least 3 months out. You want to give yourself plenty of time to be right. It also needs to be carefully analyzed before execution because if your positions are too expensive due to inflated implied volatility in the option prices, you don’t stand much of a chance of making money unless the price movement in the underlying is positively huge.

The ingredient that distinguishes the option strangle from the straddle is that, unlike the straddle where call and put options are purchased “at-the-money” a strangle position is defined by all purchased options being “out-of-the-money” (OTM). This is why a strangle is usually somewhwat cheaper than the straddle . . . out-of-the-money options have no intrinsic value, only time value. Purchasing longer dated OTM options will have more time value than near month options and therefore be more expensive, but the reduced risk from slower time decay is worth it.

Let’s illustrate an option strangle with a practical example.

Our imaginary stock is trading at $35 and we believe that within the current or next month all the signs point to a large move at least $5 in either direction. For indicators of possible upcoming large moves, see our article on the option straddle.

So we purchase 10 call option contracts with an OTM exercise price of $37.50 and another 10 put option contracts with an OTM exercise price of $32.50. Both these strike (exercise) prices are $2.50 out of the money.

Within the month, the stock price falls to $30. The put options are now $2.50 in-the-money, plus their remaining time value, so they have become quite valuable – so much so in fact, that their current value is worth more than the combined cost of the original OTM call and put options and then some. So you close out both the positions for a nice profit.

If some really bad news came out and the share price plummeted to $20, you would make even more profit from the put options. Theoretically, on the call option side, your potential profits are unlimited. On the put option side, the most a stock price can fall to is zero so that does place some limit on potential profits. But if the fall is from $35 that’s a still lot of profit.

The final, but no less important, matter to mention when deciding on an option strangle strategy, is the implied volatility in the price of the OTM options. You need to compare IV with the historical volatility (HV) of the stock and ensure that the IV (expressed as a percentage) in the option price is less or equal to the HV of the stock. In other words, make sure the options are not overpriced.

Often in periods of low stock volatility before a price breakout, the option prices will also become quite cheap. This is an ideal opportunity for a strangle trade. Once the underlying stock price becomes more volatile the options price will also reflect that volatility and increase in price more dramatically than if you had bought them during a more volatile period.

Checklist for Finding Option Strangle Candidates

Here is a summary of the conditions you should expect to identify before you consider placing a strangle trade:

1. Earnings Reports – Assuming the absence of volatile news events, options implied volatilities should be lower in between company earnings reports. Major announcements which might energise the price action will be less likely. If you’re scanning the market for strangle trade opportunities, you should begin your search by looking at stocks with upcoming earnings reports during the next fortnight.

ascending triangle pattern 2. Looking at a bar or candlestick chart of the underlying, you should be able to observe price consolidation. Comparing the size of the current daily bars with those in the past, it should be apparent that these bars are smaller than the historical ones.

You want something that has had big moves in the past – which indicates that this stock’s price DOES move – but now the price action is relatively quiet due to smaller intra-day price moves. In consolidation mode stocks also tend to have lower volumes. Under these conditions the options will normally be cheaper.

You will often find this phenomenon close to the end point of a “triangle” or “wedge” chart pattern, in your stock charts.

3. The options must be cheap.

By “cheap” we mean that the implied volatility in the at-the-money option prices must be less than the historical volatility of the underlying security. Any good options broker should be able to deliver this information. Some brokers allow you can to look at a price chart in “Volatility View” mode, so that you can easily compare Implied Volatility with the stock Historical Volatility.

If all the above conditions are in place, you have an ideal setup for an options strangle trade.