What are options - and why add them to your investing mix? TradeKing’s Brian Overby goes back to basics, explaining options for beginners. This post introduces implied volatility, or IV, and explains why it’s important in options trading.  

What is volatility in options trading, and why does it matter to traders like you? Today’s post introduces implied volatility, a key concept.

(If you’re just tuning in, check out the section below entitled “Catching up? Previous posts in the Options Guy’s back-to-basics series”.)

Some traders get off on the wrong foot by assuming volatility is directional – that is, that a volatile stock is more bullish or bearish. In fact, volatility refers to swings in stock price in EITHER direction.

Think of two kids on a swing set, one cautious and one wilder. The cautious kid swings close to the ground, neither going very high nor dropping very low but always staying close to the baseline; that’s an example of low-volatility.

The wild kid, on the other hand, likes to swing in a big arc, sailing high into the air in front of the swingset, but also dropping fast and furious in the opposite direction. A high-volatility stock can do the same; it’s likely to go way up or way down in price, but – unlike the regular arc of a kid’s swing - nobody knows in which direction the stock may swing.

Options traders are concerned with two different types of volatility: historical and implied, so let’s define those. Historical volatility is defined in textbooks as “the annualized standard deviation of past stock price movements”. In plain English, that just means how much the stock price fluctuated on a day-to-day basis over a one-year period.

Imagine a $100 stock, XYZ. If it starts trading at $100 on January 1 and ends the year back at $100, it could still have traded in a wide range of prices during the course of that year. Maybe on March 1 it hit $75, and on August 1 it was down to $25. Such a stock would definitely qualify as a historically volatile stock.

However, as the name suggests, “historical volatility” is just that – historical. What about if you want to know more about a stock’s future volatility?

Enter the second kind of volatility options traders care about, implied volatility. This figure tells you what the marketplace, via current prices, is “implying” a stock’s future volatility will be.

What do I mean by the marketplace “implying” a level of volatility? Let’s break this concept down. Every trading day, truth and rumors cause options prices to change. If earnings announcements or court decisions are coming up, traders will alter trading patterns on certain options. Those forces drive options prices up or down, independent of whatever’s happening with underlying stock prices.

Keep in mind, though, that these options’ intrinsic value isn’t changing here, only their time value. “Intrinsic” value refers to the amount by which an option is “in-the-money”; XYZ call with a 50 strike would be $2 in-the-money, or have $2 of intrinsic value, when the underlying stock, XYZ, is trading for $52.

Chances are, though, that XYZ 50 call will command a price higher than $2 – say, $3. The first two bucks of value are intrinsic; the third buck refers to the option’s time value. Options have time value quite simply because you can never tell what will happen to prices before expiration. As expiration nears, there’s less time left in which anything-and-everything could happen, and the range of possible outcomes narrows. Correspondingly, time value on options dwindles as expiration approaches.

The reason an option’s time value will change is because of changes in the perceived potential range of future price movement on the stock. Implied volatility can be derived from the cost of the option, using an options pricing model like Black-Scholes. In fact, if there were no options traded on a given stock, there’d be no way to calculate implied volatility.

Like historical volatility, IV is expressed on an annualized basis. While IV is not directly observable in the market itself, it can be crucially important to options traders trying to decide on their next move.

In my next post, we’ll discuss how heightened IV levels usually drive up options prices – and how you can factor this into your thinking as you plan options trades.

Catching up? Previous posts in the Options Guy’s back-to-basics series

We’ve defined options, both calls and puts, explained what sports and movie contracts have in common with investment options, and showed how an option contract’s terms are spelled out in its name. We’ve also explained how to read an options chain, including key concepts like delta, open interest and implied volatility.

Next I unpacked “open interest” as an important measure of an option contract’s liquidity. We also introduced delta, explained how delta is dynamic, and showed how delta can indicate probability of options expiring at least one penny in-the-money.

Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com

[image: Swing by kimrose… on Flickr]

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options available at http://www.tradeking.com/ODD.

Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.  

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While Delta represents the consensus of the marketplace as to the theoretical price movement of the option relative to the underlying security there is no guarantee that this forecast will be correct.

TradeKing provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice.

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