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 continues a discussion of implied volatility, or IV, a key concept for options traders.

Last time we introduced “implied volatility”, or IV. This forward-looking figure, derived mathematically from current options prices, tells you what the marketplace is “imploying” the volatility of the underlying stock could be in the future. We also talked about how IV isn’t directional – it can refer to price swings in EITHER direction.

Today we’ll get deeper into the discussion and show how IV changes can impact your options trades in the real markets.
(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”.)

IV is based on current options prices, which are changing constantly – that makes IV an equally dynamic number. As IV increases, options prices tend to increase (assuming all other variables hold steady), since volatility often attracts more market interest in a given contract. In other words, rising IV is good for the options owner and bad for the option seller.

The opposite is true, too. As IV decreases, so do options prices, which benefits the options seller and hurts the options owner.

Remember delta, the “Greek” that measures how much an option price should theoretically change with movements in the underlying price? There’s another Greek called vega that measures how much options prices are expected to change when IV changes. But we’ll save that discussion for a future post.

How IV can help you estimate potential range of movement on a stock

For this part, we need a little math. IV is expressed as a percentage of the stock price, indicating one “standard deviation” move over the course of a year. This makes more sense if we start with a concrete example: a $50 stock with 20% IV. 20% of the stock price is $10; that’s one standard deviation (or 1 STD). Now we can go to town with some easy statistical work.

The chart below shows the normal distribution of stock prices for a $50 stock over a year. Statistics 101 tells us that 68% of the time the stock will move in the fattest part of this range by 1 standard deviation in either direction, +$10 or =$10 or between $40 and $60.

You can flip that assumption to note that, 32% of the time, the stock is expected to trade either lower than $40 or higher than $60 – again in the course of one year. Statistics helps us get even more specific: 95% of the time the stock price will stay within 2 standard deviations ($30 - $70); 99% of the time it’ll stay within 3 STDs ($20 - $80).

Obviously, knowing the probability of the underlying stock finishing within a certain range at expiration is extremely important when determining which options you want to buy or sell, and which strategies you want to implement when.

Just don’t forget that IV is based on marketplace consensus; it’s not an ironclad figure. But you can see how it can be really handy.

In my next post we’ll go one step deeper into the math of an options pricing model to show you how to implement these useful concepts in practice. Until then!

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 ITM.

My last post moved on to introduce implied volatility, or IV.  

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

[image: Helen’s – Swinging Neon! by pixeljones 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.

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