Options with different strike prices and maturities often trade at very different price levels, making direct comparison meaningless. A more reliable method is to evaluate options through implied volatility (IV). By focusing on IV, traders can assess whether an option is potentially overpriced or underpriced relative to market conditions.
① What Is Implied Volatility?
Implied volatility represents the market’s expectations for how much the underlying stock is likely to fluctuate in the future.
Unlike historical volatility, which measures actual past price movements, implied volatility is extracted from option prices using a pricing model that incorporates:
• The current underlying price
• The option’s market price
• Interest rates
• Time to expiration
Because it reflects market consensus about uncertainty, implied volatility often provides a more accurate measure of an option’s relative value than price alone.
• When investors expect sharp price swings: Demand for options rises, option premiums increase, and implied volatility moves higher (all else being equal).
• When investors expect stability: Option demand softens, premiums decline, and implied volatility falls.
In short, implied volatility is not a forecast of direction, but rather a measure of expected magnitude of movement. Traders can use this insight to gauge sentiment and identify trading opportunities.
② Comparing Implied Volatility with Historical Volatility
Looking at implied volatility in isolation is useful, but context matters. One of the most common approaches is to compare implied volatility with historical volatility (HV)—the realized volatility of the underlying asset over a past period.
Market practitioners generally agree on two key principles:
• Implied volatility tends to exhibit mean reversion over time.
• When implied volatility deviates significantly from historical volatility, opportunities may exist.
The implication for traders, particularly those taking a delta-neutral approach, is clear:
• Low implied volatility: Options may be undervalued → consider buying options.
• High implied volatility: Options may be overpriced → consider selling options.
As a general rule of thumb:
③ Using Implied Volatility Alongside Price Trends
Implied volatility is also a valuable tool for understanding broader market sentiment. Rising IV often signals heightened uncertainty or risk, while falling IV suggests greater confidence and stability.
When combined with the underlying stock’s price trend, IV can provide important context:
• Price rising + IV falling: Confidence in the uptrend; options pricing reflects lower fear.
• Price rising + IV rising: Market is skeptical of the rally; demand for protection increases.
• Price falling + IV rising: Fear-driven environment; traders expect more volatility ahead.
• Price falling + IV falling: Market sees the decline as orderly or limited in scope.
By monitoring both price action and implied volatility, investors can form a more nuanced view of market sentiment and position themselves accordingly.
When used in conjunction with the underlying price trend, implied volatility can help us estimate where the market could be heading.
In many cases:
Final Thoughts
Implied volatility is not just a mathematical input for pricing models—it’s a powerful lens into how the market perceives future risk and uncertainty. By comparing implied volatility with historical volatility and analyzing it alongside price trends, traders gain a sharper perspective on option value and overall market sentiment.
For anyone serious about options trading, IV analysis is an indispensable part of the toolkit.
Disclaimer:
Options trading entails significant risk and is not appropriate for all customers. It is important that investors read Characteristics and Risks of Standardized Options before engaging in any options trading strategies. Opening new options positions close to or on their expiration date comes with substantial risk of losses for reasons that include potential volatility of the underlying security and limited time to expiration. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount. Supporting documentation for any claims, if applicable, will be furnished upon request.
This presentation is for informational and educational use only and is not a recommendation or endorsement of any particular investment or investment strategy. Investment information provided in this content is general in nature, strictly for illustrative purposes, and may not be appropriate for all investors. It is provided without respect to individual investors’ financial sophistication, financial situation, investment objectives, investing time horizon, or risk tolerance. You should consider the appropriateness of this information having regard to your relevant personal circumstances before making any investment decisions. Past investment performance does not indicate or guarantee future success. Returns will vary, and all investments carry risks, including loss of principal. Tradient makes no representation or warranty as to its adequacy, completeness, accuracy or timeliness for any particular purpose of the above content.