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Implied Volatility: Spotting High Vol and Aligning Your Options

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June 16, 2016
Lit fuse: How to identify explosive (or not-so-explosive) volatility in the markets and align your options strategy

Implied volatility is like gravity. You can’t directly observe it, but you know it’s there and it’s measurable. And it’s pretty important, too. Just as gravity impacts our daily lives, implied volatility is a critical ingredient in options pricing. And “what’s priced in” is a key factor in whether your options trade is profitable.

Implied vs. Historical Volatility: Expectations and Reality

Implied volatility is a statistical measure that reflects the likely range of a stock’s future price change. It’s calculated using a derivative pricing model, which is a fancy way of saying it connects the dots between the stock’s options pricing and the market’s expectations of the future.

Generally, the higher the implied volatility, the higher an option’s price, and the bigger the expected price change in the underlying stock. There’s one major caveat, though: implied volatility doesn’t predict the direction of the move; just the magnitude and probability of the move. For instance, the probability cone in figure 1 displays the probabilities of XYZ Corp. (XYZ) trading between a range of prices over time, but does not take direction into account.

Implied volatility probability analysis

FIGURE 1: PROBABILITY ANALYSIS.

A probability cone uses implied volatility to predict a range of future price outcomes. Here, implied volatility for XYZ Corp. (XYZ) is showing a 68% chance the price will land within the range designated at each future date. Image source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

On the other hand, historical volatility is a measure of a stock’s actual, or realized, volatility over time. The key difference is that historical volatility looks back over the volatility of a stock’s historical prices rather than the future volatility implied by the stock’s options. Comparing historical and implied volatility can be a useful way to understand how much expected volatility is being priced into options versus how much it actually tends to materialize. Keep in mind, however, that past performance does not guarantee future results.

All else equal, higher implied volatility relative to historical volatility suggests options are expensive, while lower implied volatility suggests options are inexpensive. 

Historical volatility versus implied volatility

FIGURE 2: HISTORICAL (BLUE) VS. IMPLIED (GREEN) VOLATILITY.

In this example, implied volatility for XYZ Corp. (XYZ) has recently declined lower than its historical volatility. One interpretation is that options are inexpensive because of lower expectations of future price movement. Image source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

The Meaning of Mean-Reverting

Implied volatility has a mean-reverting tendency, meaning there are periods when implied volatility strays from its historical average and then returns (or reverts) back to the average, or mean.

Some reasons implied volatility may deviate from its historical average include upcoming earnings announcements, uncertainty around the economy or interest rates and the Fed, or upcoming news like a ruling on a new drug or a merger or acquisition. The key is recognizing when implied volatility is at an extreme level relative to its historical average, then structuring a trade to take advantage.

For option traders who have an opinion about the future direction of a stock price, it’s the difference between buying and selling options as part of a strategy. In general, if implied volatility is high and falling, it might be advantageous to short an option and gain negative exposure to volatility. Conversely, if implied volatility is low and rising, it might be advantageous to be long an option and gain positive exposure to volatility.

Whichever options strategy you choose, you can potentially enhance a trade by aligning a directional opinion with volatility expectations.

In summary, for periods of high implied volatility, consider selling strategies such as covered calls, cash-secured or naked puts, or credit spreads.

For periods of low implied volatility, consider buying strategies such as long calls or puts, or debit spreads. 

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