Implied Volatility: Spotting High Vol and Aligning Your Options

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” can be a key factor in whether your options trade is profitable.

Implied vs. Historical Volatility: Expectations and Reality

Implied volatility (IV) 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 for the future.

Generally, the higher an option's implied volatility, the higher its price, and the bigger the expected price change in the underlying stock. There’s one major caveat, though: IV doesn’t predict the direction of the move, just the magnitude and probability. For a graphical representation, you can use a probability cone, as shown in figure 1.

A probability cone uses IV to predict a range of future price outcomes. The example stock below, with vol at 26.21%, is showing a 68.27% chance the price will land within the range designated at each future date. Why 68.27%? Statistics geeks know that, under a normal distribution, 68.27% of observations fall within one standard deviation of the mean. But you can change the cone to any probability range you want.

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 vol 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 IV relative to historical volatility suggests options are expensive, while lower IV suggests options are inexpensive. 

The Meaning of Mean-Reverting

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

Some reasons an option’s 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 accordingly.

For option traders who have an opinion about the future direction of a stock price, volatility considerations could influence the choice between buying and selling. In general, if an option’s implied volatility is high and falling, qualified traders might consider shorting an option to gain negative exposure to volatility. Conversely, if an option’s implied vol is low and rising, a trader might consider going long an option to 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.