Implied Volatility 101

Implied Volatility 101

As an Options Trader, why should I pay attention to the IV (Implied Volatility?)  Have you ever heard about a problem of becoming a “Victim of IV Crush”?  If you’re interested in learning about adding options to your investing tool box, this would be a good thing to take on and gain an understanding.

What are the elements that contribute to the value of options?  Time.  Stock Price. Strike Price.  Dividends (if there are any paid to stock holders by the underlying company.) Risk Free Interest Rates.  And, Implied Volatility.  Hmmmm…… so if it’s just one of six elements that make up the value of the options, why is it so important?  The bottom line is that the IV can behave like a Wild Card in a card game, trumping the differences in the value of the options due to changes in the stock price, time until expiration, risk free interest rates, and ex-dividend changes.

What tools are important for us to use well, in order to keep our eye on the threat (or benefit) of the IV?  First, the option chain, then the fifty-two-week history of the IV in each individual equity that you’re investing in, and the VIX.  What is an ‘Option Chain’?  A form of options prices through a list of all the options for a given security.  This is simply a listing of all the put and call option strike prices along with their cost for a given contract period of time.  There are many column headers (other than prices) available to the investor/trader.  I select those that fit on the computer screen and give me the best guidance in my decisions on these instruments:  Bid, Ask, Implied Volatility, Delta, Gamma, Theta, Vega, Volume, Open Interest, Extrinsic Value, and Intrinsic Value.   How do I find the history of the IV in each equity?  There are a variety of resources, and my favorite one is (a free internet resource.)  Once I have found the IV Index Mean 52 week High and Low, I do an easy calculation to identify the Low, Medium, and High IV this equity has demonstrated over the past year.  [Subtract the 52-week low index  mean from the 52-week high index mean; divide by 3, to determine the size of each of these three ranges; then add that number to the 52-week low to know the upper limit of the low range;  add again to the upper limit of the low range to know where the upper boundary of the medium IV has been, then the final upper range is known, too.]  The initial statement concerning ‘victim of IV crush’ is related to the chance that I’ve bought an option that was in the range of High IV.  It’s like catching a hot potato tossed my way.  If I do that, I can feel the heat and just know that juggling it quickly will prevent it from burning my hands.  I would pass it on as quickly as possible, to avoid the burn.  I view high-IV just like that except that the ‘burn’ is a big drop in the options’ value due to the IV  drop.

I haven’t even mentioned the VIX.  Where is that in this understanding?  This is a general guideline of the IV level in many equities with options.  VIX is a trademark ticker symbol for the Chicago Board Options Exchange Market Volatility Index, a popular measure of the implied volatility of S&P 500 index options.  Its nickname is the Fear Index.  When the market declines heavily the VIX becomes a sky rocket, running high.  At this time, the VIX has fallen to a low level.  It hasn’t been this low since June 2007.  WOW!  Many investors/traders may say “there’s more complacency” being seen in this stock market.  This could be helpful for the buyers of options since they may be at lower prices.  Check it out!

Emilu Bailes
OptionsANIMAL Instructor

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Emilu Bailes

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