Russell Rhoads, CFA is an instructor with The Options Institute at the Chicago Board Options Exchange. He is a financial author and editor having contributed to multiple magazines and edited several books for Wiley publishing. In 2008 he wrote Candlestick Charting For Dummies and is the author of Option Spread Trading: A Comprehensive Guide to Strategies and Tactics. Russell also wrote Trading VIX Derivatives: Trading and Hedging Strategies using VIX Futures, Options and Exchange-Traded Notes. In addition to his duties for the CBOE, he instructs a graduate level options course at the University of Illinois - Chicago and acts as an instructor for the Options Industry Council.
No option-related topic causes more head scratching and confusion than implied volatility. For the complete option newbies out there, implied volatility is one of the pricing factors that go into determining the value of an option contract. The other factors are underlying (stock) price, strike price, time to expiration, any dividend payments, and the risk free interest rate. Those other factors are easily visualized as you know how much time is left until expiration or you can see the stock price moving around. Implied volatility moves up and down based on the demand or lack of demand for an individual option contract. If the market place has more buy interest than sell interest in an option contract then the price will move higher to attract sellers. This move up would be attributed to an increase in implied volatility. Conversely, if there are more sell orders than buy orders for an option contract the price would drop and this drop in price would be caused by a drop in implied volatility.
So why do traders buy or sell options? Well every option trade should begin with a price outlook for the underlying security. If you have an outlook for IBM (IBM) stock to rise by $10.00 from $210.00 to $220.00 over the next month you may consider buying an IBM Jun 210 Call. However, if the price of that call option is $10.00 then it would not make sense to purchase that option. The option market is forecasting a $10.00 point move between now and expiration based on the premium of that contract. The price of the option is based on the consensus market forecast for IBM into June expiration and your forecast for IBM moving up by $10.00 matches what is price in by the market. The implied volatility of this IBM option is tied directly to the price of the option. If you believed IBM was only going to move up by $5.00 points over the next month you may actually consider selling that contract. Your expectation for the IBM price move is different than the market and you would be willing to sell the IBM Jun 210 Call at $10.00 because you believe it is going to be trading at $5.00 at expiration. If enough market participants agree with your forecast the result would be an abundance of sell orders that would push the price of the option lower and also result in a reduction in the implied volatility as indicated by the price of the option.
Implied volatility is quoted as an annualized number and as percent. If you remember statistics you may recall the bell curve and confidence of a one standard deviation move. Implied volatility may be converted into the forecast of price movement in the form of one standard deviation. Of course implied volatility is an annual forecast, but it may actually be converted to be used a forecast for any number of days, even a single day. The formula to take implied volatility and determine what sort of forecast is being made by the implied volatility of an option contract appears below -
Forecast = +/- (Stock Price x Implied Volatility x Sqrt(Trading Days)) / Sqrt(252)
For example consider a stock trading at 50.00 and the implied volatility is 25% with 10 trading days until expiration.
+/- (50.00 x 0.25 x Sqrt(10) / Sqrt(252)) = +/- 2.48
So using the formula and applying the bell curve from statistics the market is pricing that with 68.2% certainty the underlying stock will be between 47.52 and 52.48 10 days in the future. If this forecast is too narrow relative to your expectation you may consider buying options with the assumption that the underlying stock is going to move at a greater magnitude than what is being price in by the options. If you think the stock is going to stay in a range between 49.00 and 51.00 over the next 10 days you may consider selling options.
Every option trade begins with a forecast for the underlying and this should lead to the best option trade based on your forecast. Implied volatility can be considered the market's forecast of price changes for the underlying stock. Combining these two pieces of the puzzle should help lead to the best option to buy or sell depending on your stock price forecast.