Implied Volatility (IV) in Options Trading

Volatility is one of the main driving factors behind every option contract, as it measures the aggressiveness of the move a stock is expected to make. 

In options trading, volatility comes in two forms, called Historic Volatility (HV) and Implied Volatility (IV). 

The first is a statistical measure, reflecting fluctuations that a stock has experienced in the previous 6 to 12 months, but implied volatility changes constantly based on a number of economic catalysts.

It is embedded directly into option premiums, and is a crucial metric to understand for anyone looking to trade successfully in this space.

How Implied Volatility Works

In essence, implied volatility represents a reflection of the collective positioning and uncertainty. If the market expects a certain stock to see major price swings in the near future, the demand for option contracts in this stock usually surges immediately. 

This high demand, in turn, pushes option premiums higher, which directly translates into rising IV. 

For example, you can see a company’s stock trading quietly for months, but as the quarterly earnings report approaches, the implied volatility will surge with the options buyers rushing to hedge or speculate, which is why implied volatility is often called the wisdom of the crowd.

It is essentially the aggregation of wider expectations from all sides, by institutional hedge funds, algorithmic traders and retail speculators, all combined into a single metric.

The Relationship Between IV and HV

While implied volatility is the main metric that you’d look for in most options trading scenarios, you still cannot ignore a symbiotic relationship it has with historic volatility.

The first important scenario to consider here is in cases when implied volatility of a stock is much higher than historic volatility. 

This indicates that options on the stock are richly priced, and that premiums are much steeper for future uncertainty in anticipation of an earnings report or a regulatory shift.

The second is the inverse scenario, as an implied volatility that is lower than historic volatility of a stock indicates that the option is considered cheap, because the future volatility expectations are lower than what was historically seen.

This relationship is a good tool for risk management and trade selection, and a gauge that you can use to determine if you would be overpaying for the right to participate in the move of a stock. 

Always make sure to double check how historic and implied volatility measure against one another, as it allows for more strategic entries into spreads or naked positions.

The Danger of The IV Crush

Implied volatility crush is a major danger in options trading, as it leads to potentially catastrophic mistakes if not understood properly.

In essence, option premiums will peak at the highest levels of uncertainty in a stock’s price, such as right before quarterly earnings reports, driving implied volatility to extreme levels.

But right after the news comes out, this uncertainty vanishes, so even if the stock moves in your predicted direction, the implied volatility can drop so sharply that it also devalues your option.

We advise you to make sure to avoid this trap by looking at IV rank or IV percentile in order to determine if the current volatility levels are historically high before you ever enter a trade at a peak of uncertainty.

High readings warn that volatility compression is likely, making long option purchases riskier.

Trading Strategies Based on Volatility Conditions

Implied volatility also impacts which trading strategies are best-suited to trade with, based on whether it is at higher or lower levels.

High IV Situation

In high IV environments, option prices naturally rise, making them expensive to buy, but very lucrative to sell. 

Professional traders use these structures to collect high premiums from buyers who are panicking.

Iron Condors

Often referred to as the neutral income generator, the Iron Condors strategy is based around selling a ceiling and a floor, betting that the price of a stock will sit still and do nothing.

As long as the price stays between your sold strikes by expiration, you keep the entire premium collected.

This approach thrives on volatility contractions, so you can make much higher profits in cases when the stock price moves slightly and the IV crush happens.

Credit Spreads

With this approach, instead of just selling a naked option you buy a further out-of-the-money option as insurance.

With a bull put spread, you sell a put and buy a lower-strike put. With a bear call spread, you sell a call and buy a higher-strike call.

With this strategy, you benefit both from Theta (time decay) and from IV reversion, profiting from the evaporation of the volatility premium because you sold more expensive volatility then you bought.

Low IV Situation

When IV is low, the market is cheap, as there is no fear that a stock will see a major movement in its price. This is why more offensive approaches and buying options at a discount becomes the move to make.

Long Straddles and Strangles

Both strangles and long straddles are pure volatility plays, as you’re betting that the stock moves more than the market expects.

With a straddle, you buy a call and put at the same strike price, while with a strangle you buy them both at different strike prices, making it a cheaper approach but also one that requires a larger move to profit.

Implied volatility here can help you as any news that spikes it will increase the value of your option even without the stock making a move yet. You are essentially acting as the long Vega here, buying the potential for a volatility explosion.

Long Calls and Puts

When you are convinced a stock is going to a specific level, doing so in a low IV environment is your best-case scenario.

Because IV is low, the extrinsic value is small. If you buy a Call when IV is at 15% and the stock rallies while IV jumps to 25%, you win twice, both when the price movement and the volatility expansion happens.

Final Thoughts

As you can see, implied volatility is easily one of the most influential forces in options pricing, but it is not a standalone signal.

By understanding the relationship between implied and historical volatility, keeping a sharp eye on the calendar to avoid the potential pitfalls and matching your strategy to the current environment, you move from gambling on price to trading on probability.