How Implied Volatility (IV) Affects Options Trading: A Complete Guide

Have you ever noticed the price of an option rise or fall, yet the underlying stock didn't move at all?

That change is often due to Implied Volatility (IV), a crucial element in options trading.

IV is one of the three main components of an option's price and the only one retail traders can use to create an advantage over market makers.

But to maximize that advantage, you'll need to understand how IV works and its impact on different options strategies.

To put it simply, IV can either amplify your gains or add unexpected risk to your trades, depending on how you use it.

In this article, we'll start with an overview of IV and how to read and measure it. Then, we'll explore its impact on different options strategies while walking you through a few trade setups using Barchart's suite of options tools.

You'll learn:

• What implied volatility is and how it works
• How to measure and interpret IV using proven metrics
• Practical strategies to use IV to your advantage
• Real examples using Barchart's tools

By the end, you'll have a solid understanding of how to effectively use IV to your advantage.

Implied Volatility: How It Works and Impacts Your Options Trades

Implied Volatility, or IV, has two different interpretations in options trading, both of which are correct.

The first IV represents the market's expectations for future price movement. It doesn't tell you which direction an asset will move but how much movement traders expect.

In the second, IV represents the demand for an option, with IV rising when the demand for the option rises.

How do these two interpretations relate to each other?

Think of IV as the "price tag of uncertainty."

When uncertainty is high, such as before earnings or major announcements, IV increases, and options become more expensive.

When things are stable, IV drops, leading to cheaper options.

High IV means more expensive options, which benefits sellers collecting premium, whereas low IV favors buyers looking for affordable entries.

So, you can interpret higher option demand as an expectation for a greater move in the underlying stock.

To keep things simple, we can boil it down to two points:

• High IV = Large expected moves and higher option prices
• Low IV = Small expected moves and lower option prices

We can see this play out with the S&P 500 Volatility Index known as the VIX.

The VIX is a composite measure of the IV for the S&P 500 thirty days out.

During market drops, the VIX rises as more traders demand options on the S&P 500 because they expect equally violent snapbacks.

You can see the market plunge in 2020 coincided with a spike in the VIX as traders and investors scrambled to buy options, particularly put options to protect their portfolios.

The VIX dropped as the market rebounded and uncertainty subsided.

We also see IV increase for a stock as a company approaches earnings as traders begin to price in uncertainty around how much a stock will move. Once earnings are announced, that information void is filled, and IV drops.

This constant expansion and contraction in IV creates a condition known as mean reversion.

The further IV gets from its historical average, the more likely it is to return to that average.

That's why spikes in the VIX don't last very long, and IV returns to normal after a company releases earnings.

This is also the key to crafting an advantage as an options trader.

Measuring Your Edge

Have you ever tried to sell that $75 Halloween costume back to the store in November?

They'll happily take it off your hands for $5 because next year, they can sell it again for $75.

Costume stores make money buying when demand is low and selling when it's high.

As retail traders, we can do the same thing with options. It's all about understanding where IV is relative to its historical average.

To do that, we can use a few different metrics.

The two key metrics traders use are IV Rank and IV Percentile:

IV Rank shows where current IV sits within its 52-week range. Example: If a stock's IV is 35% within its yearly range of 30-40%, the IV rank is 50.

IV Percentile indicates how often IV has been lower than the current level over the past year. Example: If IV was lower 75% of the time in the past year, the current IV Percentile is 75%.

Mean Reversion

IV Rank is particularly popular among traders who believe in mean reversion—essentially betting that volatility will return to its average levels.

On the other hand, IV Percentile can be more useful for understanding how current IV compares to typical levels over the past year, giving a broader context for traders who want a bigger picture view.

Traders often take advantage of mean reversion by selling options when IV is far above historical norms, collecting higher premiums in the expectation that volatility will soon return to average levels, thus lowering the option's value.

Here's the problem.

With thousands of stocks to choose from and IV constantly changing, how do you find the best opportunities?

Barchart's tools provide valuable insights into IV trends.

With historical IV charts, you can easily see how current levels compare to past trends, helping you identify whether options are overpriced or underpriced. Using these tools, you can time your entries and exits more effectively, aligning your trades with market sentiment and volatility levels.

For example, when IV is significantly above its average, it might be a good time to consider selling options to collect premium before the market calms down.

Here are two practical ways to use Barchart's Options Tools:

Barchart's Options Screener

Barchart's Options Screener allows you to filter stocks based on IV Rank or IV Percentile on top of typical screener criteria such as price, volume, as well as option specific criteria to include only those stocks that have options or even those stocks with weekly options.

In the example below, we pulled in options on stocks with plenty of liquidity.

Our results populate with different call and put options at different strikes and different expiration dates

Notice how the IV Rank is the same across all the options listed for each equity. IV Rank is a composite number applied at the symbol level. So, you'll get the same IV Rank or IV Percentile for all options under the same symbol.

Using the screener is a great way to find individual options for stocks that fit your criteria.

But maybe you want to start at a higher level and just see the IV Rank and IV Percentile by stock.

Barchart's IV Rank And IV Percentile

The IV Rank And IV Percentile prepopulated screener under the Market Pulse gives you a quick screen of the stocks with the highest IV Rank or IV Percentile by ticker symbol.

With the ability to sort by column, you can quickly navigate to all the symbols that are above or below a certain threshold. And with the download feature, you can pull all the information into Excel, allowing you to quickly dissect and analyze the data.

One of the really neat features is the History tab, which allows you to dig into an individual equity and see how the IV, IV Rank, and IV Percentile changed over time.

Here we've pulled the history for the top stock from our list.

We start by pulling up the Expected Move for Gap in the options section and then compare it to the average historical move.

We want to look at the expiration date that's after but as close to the earnings release as possible.

Gap reports on Thursday, November 21st, so the next expiration date is November 22nd.

We can also see this in the implied volatility for that expiration date and any other by hovering the mouse over the dots for that expiration cycle to generate a popup window.

In this window, we see that the expected move is $2.70, or 12.72%.

If we go down to the row just below the graphic, we have the percentage moves for Gap’s prior four earnings and the average.

This data shows the average move as 17.26%, with two of the last moves coming in below 10% and two close to 30%.

If we believe the stock will move substantially more than 12.72%, we could buy a strangle, which involves buying the at-the-money put and call. We turn a profit if Gap moves more than 12.72% by expiration.

If we believe the stock will move substantially less than 12.72%, we could sell a strangle, which selling buying the at-the-money put and call. We turn a profit if Gap moves less than 12.72% by expiration.

Even if you never trade this strategy, it’s one of the best to help you understand implied volatility (Vega).

Final Thoughts

Understanding implied volatility is crucial for any options trader looking to gain an edge in the market.

By grasping how IV reflects market expectations and affects option pricing, you can better strategize your trades to align with prevailing market conditions.

Tools like Barchart's options screener and IV Rank and Percentile indicators empower you to analyze and interpret IV trends effectively.

Whether you're aiming to capitalize on high IV by selling options to collect premium or looking to purchase underpriced options during periods of low IV, incorporating IV analysis into your trading strategy can significantly enhance your decision-making process.

Remember, the key to successful options trading lies in combining solid analytical tools with a deep understanding of market dynamics.

Start leveraging implied volatility today to make more informed and profitable trading decisions.

FAQ:

What is implied volatility in simple terms?

Implied volatility (IV) reflects the market's expectation of future price swings. It shows how much the underlying asset might move, without predicting the direction.

How does IV affect options prices?

Higher IV leads to higher option premiums, benefiting sellers, while lower IV results in cheaper options, benefiting buyers.

Can implied volatility predict market crashes?

While IV doesn't predict crashes, spikes in indicators like the VIX often signal increased fear or uncertainty in the market.

What tools can I use to analyze IV?

Tools like Barchart's Options Screener and IV Rank/Percentile indicators help traders gauge implied volatility effectively.