OPTIONS TALK: Measuring the Implied Volatility Factor
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February 23, 2007
Those who are new to options trading generally find the concept of Implied Volatility [IV] a little difficult to grasp. While the underlying mathematics can be complex, the actual rating and usage is much easier once understood properly. In fact, IV can be used just like any other technical indicator. This article will explore this concept and assist the reader in its practical use.
Simply stated, Implied Volatility can be defined as how much the option could move in value based on the current underlying instruments market price. A formula is used to calculate this value. However putting the above definition aside, all an options trader needs to know is:
Buy Low IV, and Sell High IV
The practical use of the above statement is:
When Buying Options, purchase options with Low IV, and
When Selling Options, purchase options with High IV
This is the same concept as buying a stock for a low price and selling it for a high price. The question is, how can you tell if IV is Low or High? The answer is simple. IV is best measured relative to itself. This means that you need to compare the current IV value to where it has been over a period of time in the past.
Chart 1 shows the IV chart of Ebay (EBAY) traded on the NASDQ exchange in the US over a 15 month period. It highlights the IV for options greater than 90 days in time. IV can be measured in multiple timeframes and the timeframes of interest will depend on the holding period of the options bought and/or sold. For example, when looking at option strategies with greater than 90 days to expiration, the greater than 90 day IV should be analysed.
Chart 1 Measuring IV for EBAY
To determine whether IV is high or low, measure the current IV value relative to where it has been in the past. If the current IV is in the top 80% or greater, it is considered to be expensive. Alternatively, if IV is in the bottom 20% or less, it is considered to be cheap. For the EBAY chart, IV can be considered to be cheap as it is very close to the lowest value over the past 15 months. Given this information, option strategies that involve buying will give the trader the IV edge. Such strategies would include buying straight Calls and Puts, Debit Spreads, Straddles, Ratio Backspreads and Calendar Spreads. These strategies will all benefit if the stocks IV rises in value.
The theory behind IV can be quite complicated. However, in the world of trading, successful traders will learn the theory then keep it simple in application. All the option trader needs to know about IV is simply Buy Low IV and Sell High IV. If you understand how to measure IV and stick to this rule, you will be putting the IV edge in your corner.
Manage Your Risk!
Oscar Lee
Trading Tutors
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