One of the most important factors that experienced options traders consider is implied volatility, or IV. It determines whether options are relatively cheap or expensive. If IV is low, options are considered cheap.
On the other hand, when implied volatility is high, options are expensive. The Optionetics.com rankings provide lists of options that are considered cheap or expensive, and they're also based on implied volatility. Interestingly, today, many of the cheapest options are in the technology sector.
Implied volatility reflects what the options market expects in terms of a stock's future volatility. It is computed using an options-pricing model such as the one developed by Fisher Black and Myron Scholes -- a.k.a. the Black-Scholes option-pricing model. In addition to a model, a number of other variables are necessary to compute implied volatility, such as the current option price, the time left until expiration, the strike price of the option, the underlying asset's (stock) price, the prevailing interest rate and any dividends paid by the underlying stock.
Therefore, the model requires several inputs, and two of the most important -- the stock price and the option price -- are taken directly from the market. Therefore, as the name suggests, implied volatility tells us what level of volatility option prices are "implying" for the underlying stock.
As a rule, high-volatility stocks will have higher IV than low-volatility stocks. That explains why more volatile stocks have higher option premiums. Intuitively, this makes sense. For example, call options on a highly volatile stock have a greater chance of being in the money at expiration than a low-volatility stock.
Going further, take two stocks -- one that has been trading between $40 and $50 for the past two months and another that has been trading between $30 and $60. Which one would have higher option premiums afforded to the January 60 calls? Obviously, the one that has been fluctuating more in price has a greater probability of being above 60 by January expiration. Therefore, the option premiums will be higher for the stock that has been trading within a larger range.
In sum, implied volatility is the part of the options-pricing formula that explains why two equivalent options (in terms of strike prices and expiration dates) on two different stocks can have drastically different premiums.
The level of implied volatility assigned to one specific stock could change over time. For instance, a highly volatile stock that trades quietly for a period of time can see its IV fall. In that case, option traders say the options are becoming cheaper.
On the other hand, sometimes implied volatility rises and options become more expensive. Searching for cheap (low IV) or expensive (high IV) options is relatively easy to do.
On Nov. 20, I conducted a ranking of cheap options. Interestingly, the top five were technology stocks, listed in the table below. Generally, the technology sector is known more for its high -- not low -- volatility.
However, the rankings do not compare one stock's volatility with another. Instead, the cheap options are ranked based on their past levels of implied volatility. For example, consider the cheapest:
. Over the past year, it has had volatility as high as 74%. Now, however, IV is only 35%. Therefore, relative to past levels of implied volatility, Dell options are cheap.
The chart below shows the drop in Dell's IV graphically. It was created using Optionetics Platinum and encompasses a period of two years. These options have become cheap.
options are also considered cheap. However, with IV of 53%, they are much more expensive than Dell options. Still, relative to the past, Qualcomm options have become cheaper. Therefore, when considering whether options are cheap or expensive, options traders generally consider the IV of one individual stock over time, not compared to options on different stocks.
Finally, knowing whether options are cheap or expensive can help dictate which strategies to implement. For example, buying calls when options are expensive can often lead to losses -- even though the stock moves higher as anticipated. Basically, sometimes, expensive options will become cheap due to changes in implied volatility. When this happens, it is known as a volatility crush.
Therefore, it is better to be an option buyer when volatility is low and options are cheap. This is true in the technology sector right now, but rather than simply buying puts and calls, lower-risk approaches to low-IV situations include straddles, strangles and ratio backspreads.
By Frederic Ruffy, senior writer and index strategist at