Definition: Implied Volatility (IV) is an estimated price range of a stock over a certain period of time and is displayed as a percentage. The percentage is based off the current market option prices of an underlying stock and the future expectation of price movement. Using the IV percentile of a stock, a trader can figure out an estimated range that stock is likely to trade in.
For example, stock ABC is trading for $10 with an IV of 30%. This gives us a one standard deviation price move of $3 over a year in either direction. One standard deviation means that 68% of the time stock ABC should be trading in a range from $13 to $7 over the next year. As new information is introduced, the IV percentage expands and contracts.
Implied Volatility Rank (IVR)
The IVR gives us context about the IV for an underlying asset. If stock XYZ has an IV of 45%, we don’t know if that is relatively high or low. The IVR takes into account where the IV has been in the underlying asset over the past year. Let’s assume the IV of stock XYZ has been between 30% and 60% over the last 52 weeks. The IVR of stock XYZ is 50 with the current IV at 45%. Now we understand that an IV of 45% is in the middle of the range in terms of volatility for that particular stock.
In general, IVR is a great way to understand whether the stock has seen IV expansion or contraction. The ranking for volatility helps us determine which option strategies we want to implement.
Implied Volatility’s Effect on Option Premium
IV percentage and option price are positively correlated. As IV goes up, options premiums go up. As IV goes down, options premiums go down.
At Tradezy, we like to be selling options into high IV to collect a higher rate of theta decay. Some good strategies in a high IV environment include: Credit Spreads, Iron Condors, Short Straddles, and Short Strangles.
When the IV is low we would rather buy the options in hope of IV expansion and the resulting increase in option prices. Some good strategies in a low IV environment include: Debit Spreads and Calendar Spreads.