IMPLIED VOLATILITY - BUYING AND SELLING STOCK OPTIONS

Using Tools Like ChartBender Pro or Volcone Analyzer Pro, You Can Assess The Implied Volatility Of An Option To Spot Both Trading Risks And Opportunities

Implied Volatility, or Vega, has the ability to catch unsophisticated stock option traders off-guard.  One of the most common and frustrating lessons learned by new traders in the Stock Option Trading School of Hard Knocks occurs when an out-of-the-money call is purchased in anticipation of the market rising to a specific price level and, in fact, it does just that...but the call option loses value despite the favorable move.

What happened to this unsuspecting trader is a phenomenon referred to as a "volatility crush," which occurs when implied volatility rises due to uncertainty surrounding future price movement but then rapidly subsides.  Options purchased during the "volatility rush" can see their value rapidly deflate in the ensuing "volatility crush."

BUY LOW AND SELL HIGH … IMPLIED VOLATILITY, THAT IS

Implied volatility inflates the price of an option’s extrinsic value; i.e., time value. When implied volatility rises, so do option prices because the time value associated with those options is more expensive. Conversely, falling implied volatility produces cheaper options.

If you buy options when implied volatility is high, you run the risk of a subsequent drop in implied volatility and a corresponding drop in the price of your options. As an option seller you can take advantage of the rich implied volatility levels and then buy back the same options after implied volatility subsides.

Buying options when implied volatility is low reduces the chance of a subsequent drop in values and positions you to profit should implied volatility rise. Selling options in such conditions makes it difficult to close a trade prior to expiration.

ASSESSING IMPLIED VOLATILITY

Implied volatility values are relative in nature. Whether any given implied volatility reading reflects a high or low level is entirely dependent upon where volatilities have been in the past. For this reason, it is necessary to compare current implied volatility to a historical measure.

There are two historical measures that can be used for assessing current implied volatility levels. The first is the past volatility of the underlying security, which is most often referred to as “statistical” or “historic” volatility. This is a measure of how volatile the underlying security has been over time.

The second method looks at where the implied volatility for a given option has been over time. This allows you to see the actual rise and fall of IV during the life of the option.

COMPARING IMPLIED VOLATILITY AND HISTORIC VOLATILITY

A non-volatile stock that trades in well defined patterns and tight ranges will see its docile nature reflected in the implied volatility of its option chain. This is because traders will feel comfortable that the stock is likely to remain well behaved. It may trade higher or lower, but the price movements will likely not be extreme.

A highly volatile stock, one that makes wild price swings, will see higher implied volatility values throughout its option chain. Traders are less certain about where this stock is likely to trade due to the wild price swings in the past.

A very useful tool for assessing whether an option is relatively cheap or expensive is a “volatility cone” based upon the statistical or historic volatility of the underlying security. The volatility cone projects a graphical image demonstrating the maximum and minimum volatility range, as well as one and two standard deviations, for a stock or index over a period of time.

By simply referencing the current implied volatility level for any option you are considering and referencing it on the graph, you will instantly know where the market has priced the option relative to the underlying security’s past movement. An unusually high level may be considered a “sell” candidate, while a lower level might be a better “buy” candidate.

An affordable tool for making this comparison is the Volcone Analyzer Pro software, which is sold by Options University. All upgrades are made available at no additional cost, which is a comforting policy since you don't have to worry about paying for new features. The data is obtained from a free resource, so you don't have monthly fees to worry about. Online videos are available for training purposes.

If you would like a better look at software, we have arranged access to a Volcone Analyzer Pro training video.  The video not only provides a demonstration of the software, but also insight as to how a comparison of current implied volatility levels to historical volatility levels can be a beneficial exercise for a stock options trader.

LOOKING AT WHERE IMPLIED VOLATILITY WAS BEFORE

The second method of assessing current implied volatility is by comparing it with where implied volatility has been in the past. Implied volatility rises and falls. Ideally, you would prefer to buy an option when IV subsides and sell the option when it rises.

Obtaining historical implied volatility data for a specific option contract within a chain for such a comparison is not as easy as obtaining historical data for a stock or index. Typically, such data is only available through a paid data subscription.

Some brokers may provide an IV charting feature, which graphs the level of implied volatility over time. I have found these often lacking and they can be cumbersome when trying to assess a combined option position.

One of the best tools I have found for comparing current implied volatility levels to past levels of implied volatility is through the ChartBender Pro service, which allows you to construct your options position and the service will then display an IV chart for the entire combined position, allowing you to make a determination as to whether it is best to buy or sell it.

The ChartBender Pro service is a monthly subscription, but if you enter “THEOPTIONCLUB” as your promo code you will receive a substantial discount on your first couple month’s use of the service. Support is excellent and there are a series of videos on their site, which demonstrate how the service is used.

Additional Implied Volatility Resources

Volcone  Analyzer Pro Software
Know instantly whether an option is a “buy” or “sell”
candidate. One-time purchase, FREE data source,
and life-time upgrades!

ChartBender's Video Showcase
Several FREE video demonstrations of their IV analysis
tool. Use promo code “THEOPTIONCLUB” for discount
on a subscription.