Implied volatility measures the expected volatility of the underlying stock over the option’s life. It is derived from the price of the option and can be used to gauge market expectations for the stock.
Implied volatility is not a measure of actual past or future volatility but rather a forward-looking estimate of how volatile the stock is expected to be. Because it is acquired from option prices, which are themselves dependent on expectations for the future path of the underlying stock, implied volatility can be thought of as a measure of market sentiment.
Options with higher levels of implied volatility are usually more expensive than those with lower levels because investors are willing to pay more for an option when they expect the underlying stock to be more volatile.
Implied volatility is often expressed as a percentage, making comparing options with different strike prices and expiration dates easier. For example, an option with an implied volatility of 30% is considered more expensive than one with an implied volatility of 20%.
How does implied volatility affect your stock trading?
Use it as a measure of market sentiment
Implied volatility can be used as a gauge of market sentiment when participating in stocks trading. When investors expect the underlying stock to be more volatile, they will pay more for options, and implied volatility will rise. Conversely, when investors expect the stock to be less volatile, they will pay less for options, and implied volatility will fall.
Use it to find attractive options
You can use implied volatility to find options that are under or overpriced. If you think a stock is about to become more volatile, you may want to buy call options (or sell put options). Similarly, if you think a stock is about to become less volatile, you may want to buy put options (or sell call options).
Use it to hedge your portfolio
If you are worried about the potential for market volatility, you can use options to hedge your portfolio. By buying put options on your stocks, you can protect yourself against a fall in the stock price. Conversely, by buying call options on your stocks, you can protect yourself against a rise in the stock price.
Use it to speculate on stock price movements
You can also use implied volatility to speculate on the future direction of the stock price. If you think a stock is about to become more volatile, you can buy call options or sell put options. Similarly, if you think a stock is about to become less volatile, you can buy put options or sell call options.
Use it to generate income
Finally, you can use implied volatility to generate income. You can sell put options if you are bullish on the stock market. And if you are bearish on the stock market, you can sell call options.
What are the disadvantages of implied volatility?
It is not a measure of actual past or future volatility
Implied volatility is not a measure of actual past or future volatility but rather a forward-looking estimate of how volatile the stock is expected to be. It can be inaccurate and should not be used as the sole predictor of future stock price movement.
It is dependent on the underlying stock price
Implied volatility is calculated using the underlying stock price, which can be affected by factors such as changes in the stock price, interest rates, and time to expiration.
It can be challenging to interpret
Implied volatility is often expressed as a percentage, making it difficult to interpret. For example, an option with an implied volatility of 30% may not necessarily be more expensive than an option with an implied volatility of 20%. The percentage only tells you how much more (or less) the option is expected to move, not the actual dollar amount.
It can be misleading
Implied volatility can be misleading because it is a forward-looking estimate, which means that it is based on the expectations of market participants and can change rapidly. You should not use it as the sole predictor of future stock price movement.
