Understanding Implied Volatility
Wouldn't it be nice if someone could tell you which options to trade? If you had a crystal ball that showed you how an option would perform?
That might not be reality. But there is a way to have an idea of how a stock might perform. It's called the implied volatility. It's the market's opinion on how a stock will react in the next 12 months. The IV may predict how much a stock may move, but it doesn't predict the direction.
Knowing this opinion can help you decide which option, if any, is right for you.
A Closer Look at Implied Volatility
© CreditDonkey 
In more technical terms, implied volatility is a percentage of the stock price. For example, ABC stock has a 20% IV. This means the market predicts the stock will increase or decrease 20% in the next year. The IV is based on one standard deviation.
A standard deviation is a statistical term. In statistics, it means that there is a 68% chance of the IV prediction coming true. In the above example, there is a 68% chance that the stock will move 20%. It could be 20% higher or lower than its current price in 1 year.
Looking at it in simpler terms, it's a type of boundary set up for the stock's price. Knowing a stock's potential range can help you choose the right investment. You can measure the IV against your thoughts on the stock's movement. Then you can decide if and when you should buy and sell options.
Keep in mind, though, that there's still a 32% chance that the prediction won't come true. There's a 16% chance the stock could fall lower than the designated range. There's also a 16% chance it could increase even more.
ABC stock currently trades at $40/share. The implied volatility of the option contract is 30%. This means within the next year, the market predicts the stock will move up or down 30%. In other words:
$40 x .30 = $12
The stock could end up:
$40 + $12 = $52
or
$40  12 = $28
Again, this is just a prediction and it's over the course of a year. However, you could use $28 and $52 as the "boundaries" for the stock's price for investment strategy purposes.
How Implied Volatility Affects an Option's Price
Implied volatility and option prices have a direct relationship. If implied volatility increases, the option's premium increases. If the implied volatility decreases, the option's premium decreases. In other words, rising implied volatility can be bad for buyers. The option's premiums will continue to increase. This could make the option more expensive. This also increases the buyer's breakeven point.
However, a rising IV can be good for sellers. They may make an inflated premium. This can help their position. It helps lower their breakeven point in an uncertain market.
There is a flip side, though. If you already own options and want to close the position, you'll feel differently. Closing the position means:
 If you bought an option, you want to sell it back to the market to close the position.
 If you sold an option, you want to buy it back from the market to close the position.
In this case, a rising IV is good for the buyer. Since he originally bought the option, he is trying to make money back. A rising IV could mean he collects a higher premium.
The seller, on the other hand, will regret a higher IV. The higher premium means it'll cost the investor more to buy the option back. It could result in a loss depending on how much he initially paid for the option.
Figuring Out the Option's Standard Deviation for Expiration
The implied volatility shows how the price might change over a year. But the most common options contracts expire in 1 to 3 months. Knowing what it might do in a year doesn't help much.
You can use this calculation to figure out the percentage change based on the yearly IV:
Stock price x Implied volatility x v(Days to expiration/365)
Take for example, a stock price of $50 with an implied volatility of 20% and 30day expiration. It would have a standard deviation of:
$50 x .20 x √(30/365) = $2.80
In the next 30 days, the stock is predicted to move up or down $2.80.
In the next 12 months, however, the stock is expected to move a total of $10 either way.
Which Options Does IV Affect the Most?
As a general rule, implied volatility has the most effect on an atthemoney option. This option has a strike price equal to the market price. Here's an example:
ABC stock is currently trading for $50. You have a 3month call for ABC stock with a $50 strike price. You wouldn't exercise the call right now. You could buy the stock from the open market at the same price. If the option has a 20% IV, it means the stock is predicted to increase or decrease 20% over the next year.
This means over the next 3 months:
ABC stock could trade for $45 or $55.
$50 x .20 x √(90/365) = $5
If it falls to $45, your call expires worthless. You wouldn't exercise your right to buy a stock at $50/share when it's trading for $45.
But, if the stock price rose to $55, you would exercise your call. You could then buy 100 shares at $50 and then sell them for $55/share. You'd realize capital gains of $500 minus the premium you paid for the option.
Any change in the stock's price can affect your option's position.
On the other hand, deep outofthemoney or inthemoney options aren't as affected. Even a 20% predicted change won't affect your position as much.
For example:
ABC stock currently trades for $50. You have a 3month call with a $30 strike price that you haven't exercised yet. Right now you are inthemoney. You have $20 intrinsic value on the stock.
Again, the 20% implied volatility means that in the next 3 months, the stock might change $5. You are already deep in the money with a $30 call. That $5 change won't affect your position.
If the stock increases $5, it would be $55. You exercise your option at either price. If the stock falls $5, you could still exercise your option as it would trade at $45.
Using Implied Volatility in Your Strategy
As a general rule, you want to buy when the implied volatility is low and sell when it's high. This way, you buy for a lower premium and have a lower breakeven point. The longer your expiration date in this case, the better, though. It gives your stock more time to change in the direction you need.
If you sell when implied volatility is high, you increase the premiums you make on the option. Of course, high volatility means higher risk that the stock could move in the wrong direction.
The Final Word
Implied volatility shouldn't be the only thing you consider. You can, however, use it as a factor. Knowing what a stock might do in the future can help you strategize. That's what buying and selling options is all about.
More from CreditDonkey:


