In our introduction to options trading, we discussed some basics of options, like the differences between calls and puts, how options contracts work, and why options is a zero sum game.
Now we’re going to dig into the single most important options pricing concept: implied volatility.
If you don’t understand implied volatility, you don’t understand options.
Implied volatility is exactly what it sounds like: it is the amount of volatility implied by the price of an option.
Put another way, by paying a certain price for an option, we are implying that the stock will have a certain level of volatility.
There are 7 basic factors that determine an option’s price:
Factors 1-6 have something in common: they are pre-determined.
Implied volatility is different because it is determined by how much we pay for the option in question.
Options are effectively insurance.
A call option is an insurance contract that pays off when the stock rises.
And a put option is an insurance contract that pays off when the stock falls.
And like a car, the faster a stock moves, the higher it costs to insure it with options.
It costs more to insure a Dodge Viper than a Honda Odyssey minivan.
Because there’s more potential for trouble (volatility) with a 645-horsepower sports car than a minivan.
(WARNING: This video may Not be Safe for Work…)
As we’re writing this on October 17, 2017, Tesla (TSLA) is trading at $354.72.
The implied volatility on the TSLA $355 December calls expiring in 59 days is 40%.
What exactly does that 40% number mean?
To successfully trade options, you don’t need to understand all the nitty gritty of options math.
But you do need to understand the basic fundamentals of options prices.
So let’s jump back to Statistics 101 so you understand what that 40% implied volatility number means.
We use implied volatility to lay out the implied 1-standard deviation move in the underlying stock.
This is the movement that is expected 68% of the time.
Here is the formula to determine a 1 standard deviation move using implied volatility:
Stock Price * Implied Volatility * Square Root of Calendar Days/365 = 1 Standard Deviation
For our Tesla example, this becomes:
$354.72 * 40% * .40205 = $57.05
This implies a 68% chance Tesla will move $57.05 or less by expiration in December.
Put another way, it implies a 68% chance that Tesla will stay between $297.67 and $411.77. (calculated as $354.72 minus and plus $57.05)
If implied volatility was just 30% instead of 40%, there would be less implied movement.
And if it was 50%, there would be more implied movement
Take a look at this table of implied stock movements at different implied volatility readings:
As you can see, if implied volatility on our option is 30%, the implied movement (up or down) is just $42.78.
And if it was 50%, it would imply movement of $71.31!
You don’t need to do this math every time you look an option.
Just remember this: the higher the implied volatility, the more movement in the underlying stock you need to make money on the option.
Because the higher the implied volatility, the more you're paying for the option.
Remember our car insurance comparison. The insurance company will charge a lot of money to insure a 645 horsepower Dodge Viper because there’s a lot of potential for trouble.
Sellers of options are no different: if a stock can move a lot, the options seller (who is in effect selling insurance) will require a high premium for the related options.
Here is a table showing implied volatility readings for at-the-money call options expiring in 59 days on 5 popular stocks:
Applied Optoelectronics (AAOI), a very volatile semiconductor stock with a $860 million market cap, has 60% implied volatility.
Snap (SNAP), a volatile tech name, is at 54%.
And Pfizer (PFE), a slow moving pharma giant, has implied volatility of just 14%.
Why the difference?
AAOI and SNAP are much more volatile, so options seller demands higher options prices — which means higher implied volatility.
Since Pfizer doesn’t move much, the seller must charge a lower price to draw in options buyers.
Let’s take a look at our December TSLA $355 call one more time.
Using the CBOE’s options calculator, we can calculate the price of the option under various scenarios.
With a stock price of $354.72 and implied volatility of 40%, the December 355 call has a value of $22.95.
But if we assume implied volatility of 30%, the value of the option drops to just $17.28.
Here’s a table showing the value of the option at different implied volatility levels:
As you can see, at 50% implied volatility, the option would be worth $28.61.
As we’ll discuss in our next article on time decay (or theta), options are decaying assets.
All things being equal, an option loses value every single day.
You need movement — or volatility — in your favor to offset the impact of that time decay.
So when you buy an option, you are essentially going long volatility on the underlying stock, ETF, index, or commodity.
You are saying that the actual volatility in the future will be greater than the implied volatility that is currently priced in.
And all things being equal, if you are long options, you want implied volatility to rise.
However, there are some differences between calls and puts.
When stocks fall, implied volatility typically rises.
That’s great for owners of put options.
But it’s not so good for calls, because a falling stock price will hurt the options price, and offset the impact of higher implied volatility.
When a company has an event on the calendar, like an earnings report or product announcement, implied volatility for options expiring at dates around the event will increase.
Because news can drive higher-than-average volatility, so in turn, option sellers charge higher premiums.
Let’s take a look at implied volatility readings for at-the-money Apple (AAPL) $160 call options across a selection of strike prices:
As you can see, implied volatility takes a big jump with the 11/3 expiration.
Because Apple reports earnings on 11/2.
That means there is a higher likelihood of a large stock price movement after 11/2.
So the option sellers will demand higher prices for options expiring after that.
After a company reports earnings, implied volatility on its options often drop dramatically.
This is because the mystery of the earnings report is out the way, and trading returns to “normal.”
For example, Netflix (NFLX) reported earnings after the close on October 16, 2017.
That day, at-the-money options expiring on October 20 had implied volatility around 80%.
They dropped to just 30% the next day!
Remember, if you are using call or put options to speculate on an earnings report, you usually need a very large move to overcome the post-earnings drop in volatility.
Back to our Netflix example: let's assume we bought $202.50 puts expiring on October 20 because we believed the stock would fall after earnings.
The stock did fall… but not enough for the options to pay off.
In fact, even though Netflix fell -1.5% after earnings, the value of the $202.50 put option dropped by -48%!
Because a much bigger move was priced in, and the stock only made a small move.
When a merger is announced, implied volatility on the options of the target company typically collapse.
For example, in August 2017, Gilead (GILD) announced the acquisition of Kite Pharmaceuticals (KITE).
Subsequently, implied volatility readings on KITE options fell to almost zero.
Can you guess why that would be?
As you may have predicted, it's because the stock of KITE is unlikely to move since it is being acquired at a fixed price.
No one will pay up for options on a stock that is unlikely to move.
However, if implied volatility readings of a target company's options stay high, keep an eye out — there could be a higher bid on the way!
Most of the time, implied volatility will be slightly higher for puts than calls.
This is because traders will typically pay up more for downside protection through puts.
Don’t obsess over the math.
It’s more important to understand the fundamentals behind implied volatility than the exact calculations.
So remember the basics:
Check out our next article, which delves into time decay (also known as theta) — another key options pricing concept.
Did you miss the intro to this educational options trading series?
Click here to read it.