Option Volatility Made Easy

05/19/2011 10:55 am EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Options expert Dan Passarelli uses simple terms to explain what implied volatility is and how traders can use it to decide on an appropriate trading strategy.

Option traders especially, but all traders hear about implied volatility and how it affects your trading strategy. Our guest today is Dan Passarelli. He's an options expert here to talk about implied volatility. So, Dan, let's define it. What is implied volatility?

In simple terms, implied volatility is the volatility component embedded in an options price. We can get a little bit fancier with that, but in a nutshell, that's really it.

The analogy that I like to use a lot is people talk about options being insurance policies, right? You can insure a stock by buying a put.

Well, just like with any other insurance policy—take car insurance for example—if somebody is really a reckless driver, the insurance company thinks they're a big risk. So they charge them a higher premium for their policy. Somebody who is a very safe driver, the insurance policy thinks they are not a big risk, so they pay a lot less.

That's exactly how options work, and that component that sort of measures that perception of risk or perception of volatility, that's implied volatility.

Alright, so when I read articles about options, I read about the “implieds” increasing or decreasing. What are they talking about there?

In a nutshell, it's relatively how expensive are options?

You know, like obviously calls make money as the stock goes up and lose money as the stock goes down, but what if the stock doesn't go up or down? Options can still get more or less expensive, and that nuance of an options price is called implied volatility.

So, when I'm talking volatility overall of the market and the VIX is low, is that the same thing?

Yeah, it's exactly the same thing. The Volatility Index (VIX) is a great benchmark because it tells you overall, how expensive are options? Are they cheap to buy right now, or are they really expensive to buy right now?

People look at the S&P 500 Index (SPX) as a benchmark for how stocks are doing. The VIX, that's just a benchmark for how options are doing, cheap or expensive.

NEXT: Tips for Trading in Low-Volatility Conditions

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We've had low volatility for a long time here. I know that that puts a crimp in a lot of people's options strategies. Do you differ in your decision making personally when you're trading options in a low-volatility environment?

Yeah, because when options are cheaper, I might implement more option buying strategies instead of option selling strategies because, you know, it's really common to do both with options.

I can do things like income trading, iron condors and butterflies and such, or I can do things like volatility buying—buying long calls or long puts or long straddles.

So when volatility is really cheap, I'm more apt to buy those options because, in relative terms, they're cheaper.

Alright, so in an option chain, how do I view implied volatilities? Is it a number or what does it look like?

Most option-friendly brokers allow you to configure a column that has implied volatility in there. It's probably displayed 0.25. There might be a percentage sign afterwards. If there's not a percentage sign, you can just read that in. They just sort of left it off, but it is a percentage.

What it is, it is the annualized standard deviation. That's the units that it's measured in. So it's basically a percentage of the stock price in terms of annualized standard deviation.

And am I looking for a specific number? Will months that are further out in expiration have a lower implied or a higher implied volatility? What does that tell me about which one I should be buying or selling?

Further-out months may have higher implieds or they may have lower implieds. It's called the term-structure volatility, or horizontal skew.

You know, if you're trying to decide, I want to do an option selling strategy, but I'm not sure if I should sell the Mays or Junes, which is more expensive? If you want to sell options, wouldn't you rather sell the more expensive options? So look at that term-structure volatility. If you're selling, sell the higher month; if you're buying, buy the lower month.

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