Implied Volatility Explained
Implied volatility (IV) is a crucial concept in options trading that helps traders understand market expectations and make informed decisions. This guide will help you understand how IV affects option prices and trading strategies.
What is Implied Volatility?
Definition
Implied volatility is the market's forecast of a likely movement in a security's price. It's derived from the option's price and represents the market's expectation of future volatility.
Key Characteristics:
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Expressed as a percentage
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Forward-looking measure
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Changes with market conditions
How IV Affects Option Prices
Higher IV
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Higher option premiums
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More expensive options
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Better for sellers
Lower IV
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Lower option premiums
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Cheaper options
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Better for buyers
IV Percentile and Rank
Understanding IV Percentile
IV percentile tells you where current IV stands relative to its historical range. This helps traders identify if options are relatively expensive or cheap.
Interpretation:
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High percentile (>80%): Options are expensive
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Low percentile (<20%): Options are cheap
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Middle range: Options are fairly priced
Trading Strategies Based on IV
High IV Environment
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Sell options (premium selling)
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Use defined-risk spreads
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Consider volatility mean reversion
Low IV Environment
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Buy options (directional trades)
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Use long options strategies
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Consider volatility expansion
IV Crush and Earnings
Understanding IV Crush
IV crush occurs when implied volatility drops significantly after a major event (like earnings announcements), causing option prices to fall even if the underlying stock moves in your favor.
Trading Around Earnings:
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IV typically rises before earnings
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IV drops after earnings announcement
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Consider calendar spreads
Remember: While IV is a powerful tool, it should be used in conjunction with other analysis methods. Past IV levels don't guarantee future performance.