Updated: Aug 22
Are you fully aware of how the implied volatility affects your positions? This is such a complex concept most traders struggle with. However, understanding how to use implied volatility to trade options can lead to unbelievable returns if you learn how to use it at your advantage.
How to estimate Implied Volatility
Implied volatility (IV) is one of the main factors impacting on the options premium. To be profitable in options trading, you need to be aware of the amount of implied volatility that each option traded carries and evaluate the trade feasibility.
Anytime an option trade is entered, you decide to buy or sell a certain amount of implied volatility within the options premium. As the IV value fluctuates all the time, it is actually really challenging to evaluate if the implied volatility carried by options is at high, low or medium level.
Brief reminder: options with high IV are considered expensive, while those with low IV cheap. Traders make a big effort in trying to understand the IV levels so as to make their trading decisions. Their main purpose is to purchase underpriced options (low IV) and sell overpriced ones (high IV).
In this article, I have listed the 5 main factors impacting on the implied volatility value. These factors, which can be used to estimate at which level the IV is for each traded option, are as follows:
Overall market analysis - The VIX;
Implied volatility of the underlying security traded;
Relation between implied and historical volatility;
Implied volatility range;
Implied volatility and effect of time decay.
Overall Market Analysis - The VIX
First of all, you should analyze the VIX (CBOE market volatility index) to have a big picture of the implied volatility of the market as whole. This index was created in the Chicago Board Options Exchange in the early eighties and from then has become the most popular measure of the implied volatility of the S&P500 index.
The VIX is often recognized as the fear index, because it gauges the market’s expectation over the next 30 days. Its trend is exactly the reverse of the S&P500 trend, because usually volatility rises when the stock market plummets and vice versa. A high value of the VIX index corresponds to a high volatile market that causes a rise in the price of options.
Having a look at the VIX chart, you should be able to understand which sentiment (fear or greed) is generally prevailing on the market. At this point, you need to compare this value with the IV of the underlying security selected and establish if the IV of that particular stock can be considered higher, lower or almost the same than the VIX value.
Implied Volatility of the Underlying Security Traded
Analyze the implied volatility of the underlying security to trade (e.g. Microsoft Corporation - MSFT) by comparing the current IV to the past IV over a period of a year.
In order to identify if the IV value is relatively high, low or almost equal if compared to the past, I do utilize the percentile of volatility. In other words, I consider the lowest, the highest and the current value of the IV found during the year. My purpose is to find in which percentile falls the current value of IV.
Let's consider an example to make it easier to understand. Imagine that MSFT has got the IV data as follows over a period of a year:
IV lowest value = 20
IV highest value = 120
IV current value = 92
First of all, let's determine the interval of each percentile.
120-20 = 100/10 = 10
This will be your percentile matrix:
1° percentile 20 - 30 Lowest
2° percentile 30 - 40
3° percentile 40 - 50
4° percentile 50 - 60
5° percentile 60 - 70
6° percentile 70 - 80
7° percentile 80 - 90
8° percentile 90 - 100
9° percentile 100 - 110
10° percentile 110 - 120 Highest
From the example is clear that the current value 92 is in the 8° percentile. As a result, you may consider the current IV being at a high level because is close to the highest value of the year.
Relation between Implied Volatility and Historical Volatility
Analyze the implied volatility (IV) and the historical volatility (HV) of the underlying security traded. Compare these two indicators over a period of a year utilizing the IV chart and the HV chart.
In most trading platforms (ThinkorSwim by TD Ameritrade, Interactive Brokers, etc), the IV and HV charts are often considered as studies or technical indicators that can be added to any stock chart. For instance, ThinkorSwim allows traders to set charts with one or more studies and display such indicators upon each other on the some stock chart.
Once placed both technical indicators on the same chart, compare the IV and HV over the same period of time. There may be the following three scenarios:
Implied volatility higher than historical volatility (IV>HV); given other circumstances options may be regarded as relatively expensive and convenient to sell.
Implied volatility lower than historical volatility (IV<HV); given other circumstances options may be regarded as relatively cheap and convenient to buy.
Implied volatility approximately the same value than historical volatility (IV=HV); options may be not too expensive and not too cheap. You may either buy or sell options.
The Volatility Range - How to Use Implied Volatility to Trade Options Strategies
The implied volatility is a cyclic value. You should be able to understand in which IV trend an underlying security is being traded. Furthermore, you may consider the time during the year when the highest or lowest value were experienced in order to make sure of the IV trend. In fact, the IV might be in an uptrend or downtrend and this circumstance may lead to different decisions depending on the strategy traded.
For example, if the IV - at 92 - is experiencing an uptrend (it is increasing again towards the IV highest point - at 120 - already reached in the beginning of the year), even though the IV is high may be not convenient shorting options because the increase in IV may likely involve a loss.
Consequently, in a time of increasing volatility on the market, even though a certain security is being traded at a high volatility value, it may happen that the uncertainty in the market keeps going up steadily involving a rise in IV. For that reason, it is important for traders try to understand the turning points of such trend.
As a rule of thumb, can be considered cheap options those that are traded at the low end of their implied volatility range, priced at less than the volatility of the underlying. On the other side, can be considered expensive options those that are traded at the high end of their range, priced at more than the volatility of the underlying security.
Implied Volatility and Effect of Time Decay
The implied volatility is strongly influenced by the effect of time. Generally, the value of implied volatility becomes higher as options approach to expiration. In fact, as options get closer to the expiration date, the IV percentage change more quickly due to an increased degree of uncertainty.
However, although absolutely true, this statement may mislead traders when it comes to the real effect of IV on the option premium. In fact, the impact of implied volatility on the price is directly related to the amount of time left on your options.
As a result, although the implied volatility may appear higher in absolute terms as expiration approaches, the IV has definitely a stronger impact on the price of longer-term options due to the higher amount of time value left till expiration.
How to trade implied volatility in the ThinkorSwim Trading Platform
In order to analyze the IV of each option and the IV chart in the ThinkorSwim platform, please follow the procedure outlined below.
In the “analyze” tab, “add simulated trades”, type in a ticker (e.g. MSFT - Microsoft Corporation) and then click on the section “options”. A list of all options available divided for expiration date (monthly) will come out. Click on one of that expiration to have a list of all strikes available for that month.
In that list there are a series of columns showing different information (bid X, ask X, net change and last X) either for call and put options. At any time, you can change any column in order to put in the information that fit your trading style the best. To do so, go to the “layout” menu on the top right of this section and select a configuration containing the IV “Impl Vol”. This feature allows you to customize any configuration including the information you want. For instance, I have personally picked the following: Implied Volatility, Probability of Expiration, Delta, and Open Interest.
Now, you can read the IV of each option. It is represented as a percentage and moves continuously as the stock price of the underlying fluctuates.
As a rule of thumb, you should be buying options with low IV to minimize the premiums purchased and selling options with high IV to maximize the premiums sold. Unfortunately, it is not so simple. It takes a great deal of time and study to master this number. This is something I explain scrupulously in my 1-2-1 mentoring programs as we analyze each individual option strategy.