Aligning Your Options with Implied Volatility

Implied volatility (IV) is like gravity. You can't directly observe it, but you know it's there, and it's measurable. And it's pretty important too. Just as gravity impacts our daily lives, implied volatility is an essential ingredient in options pricing. And "what's priced in" can be a key factor in determining the outcome of an options trade.

Expressed as a percentage, implied volatility (IV) is computed using an options-pricing model and reflects the market's expectations for the future volatility of the underlying stock. For example, if the IV of XYZ 30-day options is 25% and similar options on ZYX have IV of 50%, ZYX shares are expected to see greater volatility than XYZ shares over the next 30 days. IV can change often and will vary from one option to the next, even when the options are on the same underlying stock.

All else equal, the higher the IV of an option, the higher the options premium, and therefore a bigger expected price change in the underlying stock. There's one major caveat, though: IV doesn't say anything about the direction of the move, just the magnitude and probability. For a graphical representation of the probabilities for an underlying stock's potential moves, traders can use a probability cone on thinkorswim^® (see image below).

To view a probability cone on thinkorswim, select Probability Analysis under the Analyze tab. A probability cone uses IV to depict a range of potential price outcomes for a specific level of volatility. The example stock below, with IV at 26.21%, is showing a 68.27% chance the price will land within the range of the cone at each future date. Why 68.27%? Under a normal distribution, 68.27% of observations fall within one standard deviation of the mean. But the probability range can also be adjusted to show probabilities based on two or three deviations.

Sometimes referred to as actual or realized volatility, historical volatility (HV) is a measure based on a stock's daily price moves over a specific time frame, such as 20, 30, or 50 days. While IV reflects future expectations, HV looks backward. Comparing HV and IV can be a useful way to understand how much expected volatility is being priced into options versus how volatile the stock was in the past (see image below). Keep in mind, however, past performance doesn't guarantee future results.

All else equal, higher IV relative to HV might suggest options are expensive, while lower IV might suggest options are inexpensive. However, because markets are forward-looking and relatively efficient, disparities between IV and HV are not necessarily a sign that options are mispriced. Rather, the high or low IV could potentially reflect market expectations that the volatility of the underlying stock might be different going forward than it was in the past.

Implied volatility can sometimes display a mean-reverting tendency, suggesting there are periods when it strays from its previous average and then returns (or reverts) back to the average, or the mean.

The IV of an option may deviate from its previous average ahead of stock-moving events, including earnings announcements, important economic data, Federal Reserve meetings, or company-specific news like a ruling on a new drug, a new product announcement, or a shareholder vote on a merger or acquisition.

Recognizing when IV is at an extreme level relative to its historical average can help identify events that might potentially move the underlying stock price, and it can sometimes help in strategy selection as well. For option traders who suspect a stock's trend reversal in the future, IV levels would likely be a secondary consideration but could influence the choice between buying and selling. In general, when the IV of an option is high and falling, some traders might consider shorting an option to gain negative exposure to volatility. Conversely, if the IV of an option is low and rising, some traders might consider going long an option to gain positive exposure to volatility.

For example, in periods of high IV, some traders consider selling strategies like covered calls¹, cash-secured² or naked puts³, or credit spreads⁴. On the other hand, for periods of low IV, some traders consider buying strategies like long calls or puts or debit spreads⁵.

Whichever options strategy you select, you can potentially enhance a trade by aligning a directional opinion with volatility expectations. At the very least, comparing current IV to past IV (and historical volatility) can potentially help a trader better understand whether the market is implying an increase or decrease in an underlying stock's future volatility.