So I touched on Implied Volatility in a recent post, but I feel as though there is more to say on the subject. It’s really one of the most important things to consider as an active trader, so the more that we can learn about it, the better.
So for a quick recap, volatility is the measure of uncertainty in the marketplace. A high implied volatility means that there is a lot of “fear” or unpredictability occurring. A high IV means that there is a greater chance for a larger move in the underlying’s price.
So, if we had an IV of 20%, and our stock was $150, this means that we could have an implied move +/- $30: so between $120 and $180. The higher the IV is, the higher the implied move is, and the farther the probabilities are from the stock price. That means that we can go pretty far out on the legs of our trades (reducing risk) and still collect a pretty decent amount of premium.
Take a strangle, for example. In this trade, we sell a put and we sell a call about 1 standard deviation (16 deltas) away from the stock price. The higher the implied volatility, the farther that we can get away from the stock price, which, as mentioned earlier, reduces our risk. With a strangle, we like the stock price to remain between our 2 strikes- and we have a greater chance of that happening the farther out that we go with our “legs” or option contracts.
So basically, we look to overpriced or high volatility as a mean reverting opportunity. When the volatility contracts, or decreases, that’s when we make our money. Based on the law of large numbers, stationary variables like implied volatility have a baseline, or a mean, that they return to after upticks or downticks. It’s like unemployment- we can have wide swings up or down, but it consistently returns to and remains around that 4.5-5%
When volatility contracts, that means that prices are contracting. As we look to sell in these high IV environments, that’s good news for us! We can now buy back at a lower price, which results in increased profits.
Basically, IV is super important, but it shouldn’t be our only determinant in selecting a trade. We should look at a bundle of other things, like delta, theta, and the numbers of days left to expiration. But make sure to take advantage of this high IV opportunities- it reduces your risk without reducing your reward!
Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.