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On Friday, I mentioned the VIX, which measures implied volatility for the S&P 500 based on the price of index options. I want to pick up where we left off and talk about how implied volatility impacts options contracts.
The VIX measures the expected movement of asset prices over the next 30 days. Most investors think that the implied volatility of an individual stock is linked only to a directional trend in the price. That’s not the case. Implied volatility is the forecast of an asset’s likely price movement regardless of the direction.
I’ve covered the basics of options many times in TradeSmith Daily. Investors use options for various reasons. For example, they might use call options to speculate on potential upward price movement.
They might sell call options to generate income on their existing stock positions. They might also use options to hedge their current positions against a possible pullback in the underlying stock.
Whatever the reason, it’s essential to understand that implied volatility projects significant price movements in a stock and thus for the associated options contracts, too.
Today, I want to talk about the basics of using implied volatility to your advantage when trading options.
Remember the Basics
I’ve explained before that options are contracts that derive their value from the underlying asset. Two primary factors impact the price of an option.
The first is the intrinsic value. This is the easy part.
Let’s say that you buy a $10 call option on a stock trading for $15 today. You have the right (but not the obligation) to purchase 100 shares of the stock for $10 apiece. You can immediately sell the stock on the market for $15 — the underlying asset’s value impacts the intrinsic value.
The intrinsic value of this hypothetical call option is the stock’s price minus the strike value of the in-the-money contract. In this case ($15 – $10), the intrinsic value is $5.
This exact measurement would happen with puts as well. If you buy a put with a strike price of $10, you have the right (but not the obligation) to sell that stock on or before the expiration date at that price. If the stock is trading for $5, then the intrinsic value of the put ($10 – $5) would be $5.
Measuring Excess Premium
The second major component of an option’s premium is the time value.
Time value is all excess value outside of the intrinsic value.
For example, how much money is the buyer of an options contract willing to pay beyond the intrinsic value? In some ways, it’s a measure of hope that a price moves. In other ways, it’s a deep statistical analysis attempting to predict future moves.
The time value is linked from the current date to the expiration date of the contract. Time value ties in the strike price, expiration date, interest rate, cost of carry, and/or dividend payments.
But nothing is more important to that excess value than the implied volatility.
Options premiums have a much higher time value when the implied volatility has increased and a lower time value when implied volatility has decreased.
Remember, the implied volatility is the expected movement in the price of the underlying stock or asset. Therefore, when the stock’s implied volatility is higher, it will increase the contract’s potential value, since there is an expectation of larger price movements in the future.
Actions to Take with Options
When implied volatility is low, the market is not expecting the stock price to move significantly in the future. Conversely, when the implied volatility is high, the market expects significant moves on the stock price in the future.
So, investors must understand that they can exploit future expectations to make money.
Typically, the time to purchase call options is when the implied volatility is low compared to a specific time frame. Therefore, a key term to follow is the implied volatility rank (IVR). This is a measurement of current volatility compared to a historical range, and it is ranked on a scale of 0 to 100.
So, let’s say that a stock’s implied volatility has moved between 10 and 50 over the last 52 weeks. If the current implied volatility is 40, this would mean its IVR is 75% — toward the top of the historical range.
That means implied volatility is high based on a full year of data. However, even if you look at the implied volatility and the number seems low, you might find that using this rank indicates historically high volatility and thus signals a greater expectation of price movement than over the last year.
Buy Low, Sell High
The general rule is that a historically low IVR benefits investors who want to buy options, and a high IVR represents an opportunity to sell options.
Remember, a lower time value would give call or put buyers the benefit of using leverage to maximize gains and limit the required amount of capital to afford the premium.
Meanwhile, a higher IVR might signal a higher expected move in prices and thus increase the time value. At this point, investors might want to consider selling contracts to take advantage of expected shifts in price.
If you own 100 shares of a stock and can sell a covered call while implied volatility is historically high, you can capture a more expensive time value and thus a higher premium.
There are many other options strategies that investors can use in high- or low-volatility conditions. I’ll discuss which ones you can use to buy, and which ones you should use to sell, in the days ahead.