Options Trading use implied volatility (IV) to measure the market’s expectation of an asset’s future volatility. Higher IV means the market expects more price movement in the future, and low IV suggests that traders expect the little movement to occur.
Options with high implied volatility are more expensive than those with low IV because investors can buy low-IV options to hedge their position at a lower cost than they could be using higher-IV options. One important traders must consider when using implied volatility as an indicator is that it does not always move in line with realized volatility, which measures an asset’s actual volatility over time.
Covered Topics
What is Implied Volatility?
According to experts at tastytrade, “Implied volatility (IV) in the stock market refers to the implied magnitude, or one standard deviation range, of potential movement away from the stock price in a year’s time.” As you may have guessed, volatility is simply how much a stock or other asset fluctuates up and down during a given period. So implied volatility is essentially predicted price movement. If investors think that an asset will move significantly in one direction or another over time, they are more likely to make trades with these assets, ultimately increasing their prices.
Implied Volatility Rank
The implied volatility rank, or IV Rank, is a technical indicator that ranks how overbought or oversold underlying security is. Implied volatility rank is also known as relative implied volatility. You can calculate it using three different methods: for one stock compared against its historical price movement, compared against broad market indexes, or compared against other stocks within a sector. Experts refer to the first two as intersegment analysis, while they even refer to the third as intersegment analysis.
Understanding Implied Volatility
Implied volatility is a fancy way of saying option price. When buying an option, you are paying for that option based on what its price is right now. For example, a stock option has two components: intrinsic value and time value. We define intrinsic value as how much more or less your option will be worth when it expires, compared to its price today.
VIX Indices
The VIX measures implied volatility of S&P 500 index options. Since it’s a measure of implied rather than historical volatility, there can be sharp drops or rises when markets open. In addition, since implied volatilities rise during market sell-offs, VIX is an excellent tool for identifying turning points in financial markets. But you have to understand how to read its data correctly.
Implied volatility is a statistical measurement of how much we expect an option’s price to fluctuate and can provide useful insight into different options strategies. Each option strategy is better with implied volatilities than others, so it’s important to know which volatilities you should target for each trade. Of course, every trader has a unique personality and risk tolerance, but if you were hoping for any hard-and-fast rules, I’m sorry—there are none.
