For the new trader first entering the world of options it is important to recognize that there are more “moving parts” than those the equity trader confronts. The world of the stock trader is largely ruled by price alone. However, the landscape with which an options trader must deal is ruled by three major factors: price of the underlying, time to expiration, and implied volatility. These three factors represent the major variables which are necessary to calculate prices using the generally accepted option pricing models. Of these three primal factors, the first two are easily understood by anyone with access to market quotes and a calendar. The two distinct concepts of volatility require a bit more understanding.

For the student of options, volatility comes in two forms: **historic volatility** (HV) and implied volatility (IV). It is critical to understand the difference because the two concepts reflect different points of view. HV, also termed statistical volatility by some writers, is a simple calculation of the volatility of the underlying as it has actually occurred over various periods of time. While the precise method of calculation can be argued endlessly, HV represents an objective measurement that requires only the input of the variable of historic price movement.

A clear understanding of the impact of IV is essential for learning to navigate successfully the world of the options markets. Failure to understand and allow for the impact of IV and its various nuances is a major cause of failure for aspiring option traders. The concept of IV is so central to the knowledge of option behavior that when “vol” is discussed among option traders, it is virtually always IV that is being discussed, not HV.

IV is a bit different from HV and must be derived indirectly. IV values are calculated by solving the option pricing models “backwards”. Pricing models for options are largely dependent on the inputs of price of the underlying, time to expiration, and IV. Given the market price for an option, these models can be solved for IV since we know the prices of the option and the underlying as well as knowing the time to expiration.

IV represents a different concept from the mechanical precision of HV which is based entirely on the historic price behavior of the underlying. IV is a subjective value which can change with varying views of the probability of future movement of the underlying. Of the three fundamental major forces impacting option price, IV is the only one subject to negotiation. It is the only variable by which both the general market sentiment and the opinion of future volatility and price direction of the specific underlying can be factored into the pricing equation. Because of this, it is a variable looking into the future as opposed to HV which is reflective of only historic price volatility demonstrated by the underlying.

While this distinction may seem of academic interest only, it has major practical impact for the options trader. Failure to consider the current position of implied volatility will routinely negatively impact trades and is the most frequent cause of unexpected behavior of option prices.

In order to illustrate the significant impact that changes in IV can have on option prices, consider the following example:

*The December at-the-money call for IBM, the 145 strike, is currently priced at $1.96 and has an IV of 15.5%. This IV is in the lower end of the historic range for IBM options. If the IV were to return toward the higher end of historic range, say 25.5%, the option would be priced at $3.10.*

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One of the critical factors with which the trader needs to be familiar is the predictable ebb and flow of IV around upcoming events. IV typically increases for a variety of reasons as events approach that could reasonably be expected to increase the probability of a significant price move. Such events include: earnings release, FDA announcements, major press releases, and regulatory decisions. When the uncertainty of the impact of a known event has passed, the release of an earnings report for example, IV tends to revert to its mean value.

New options traders frequently encounter the unpleasant result of such a sequence of predictable events. The classic story is that a trader new to options buys at-the-money calls anticipating a good earnings release resulting in a price increase for the stock. The earnings release is indeed good and the equity price rises. Unfortunately, little if any of this increase is reflected in the price of the option our trader holds. What has happened? The IV of the option has decreased, resulting in a reduction of the option premium. Our trader has been on the receiving end of “volatility crush” as IV reverts to the mean.

The purpose of this article is to introduce the importance of incorporating IV considerations into your option trading. The essential points include:

- Volatility comes in two types, IV and HV. Implied volatility (IV) is far more important for option traders
- IV effects exert a major force on option pricing
- There are certain consistent changes in IV which relate to uncertainty surrounding defined events expected to result in significant changes in the price of the underlying

While this additional factor may appear to introduce insurmountable complications, in reality it gives the opportunity for profiting from an additional relatively predictable variable.

Do you have an experiences with IV affecting your position that you would like to share? Leave a comment below!

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{ 2 comments… read them below or add one }

This is an excellent article! Thanks!

One question left unanswered is how do we tell when the IV is above or below the mean? Do we chart the IV and HV together on a graph?

Rick:

Thanks for the comment. My next post will address your question in more detail, but the quick answer is that you can find historical databases containing values for both IV and HV that are displayed together in graphical format. Probably the easiest place to find it is from your broker’s data if you have an option friendly broker. Another good source is IVolatility.com.