Implied volatility (IV) represents the expected volatility of the underlying (usually stock) over the life of an option. As the expectations of the underlying changes, so does the option premium. This is influenced by the basics of supply and demand. Naturally, other factors can change the premium, like the underlying’s movement and time, but here we will focus solely on IV.

Option Vega

Option vega is the option greek that measures changes in an option’s price due to changes in IV levels. Keeping it simple, for every 1% change in IV, vega will change the option premium by that amount. If IV rises, vega will increase the premium by that amount and vice versa. Let’s look at how to take IV into account.

Market IV

As a general rule of thumb for option traders, when the market goes down, option prices and IV tend to rise. The fear factor of a decline raises prices. When markets generally rise or at least don’t fall, option prices and IV tend to decrease or at least hold steady. As an option trader, understanding this can go a long way without getting too technical. For example, if IV and option prices are elevated, it is a good time to consider selling premium. But many option traders will do this blindly when IV levels are higher and disregard what the underlying may do. They might have sold expensive premium, but other factors they may have overlooked caused them to lose money.

For example, if the market has recently fallen, causing IV levels to increase, but a rally higher is soon expected, it may be a good time to consider a bullish position like a long call. A long call, like a long put, has positive vega. If the market and the underlying are expected to rise, most likely IV levels will fall. That means a positive vega position, like a long call, will lose premium with the IV level dropping based on IV alone. As an option trader, you might consider a spread trade that consists of a short option like a short call. Short options (both calls and puts) have negative vega and benefit from a decrease in IV. Implementing a bull call spread would be a good example of offsetting positive vega risk.

IV Spreads and Calendars

As mentioned above, when the market and/or stocks fall, generally IV levels increase along with option premium. But many times this also produces IV skews between expirations that can give an option trader an edge. It is advantageous to sell higher IV and buy lower IV. That will happen more frequently when overall IV levels are higher.

Take, for example, a long calendar. A long calendar is when an option trader sells an option and buys the same strike option with a longer expiration. The strategy generally benefits from time decay, but an IV skew can reduce overall risk. The option trader looks to sell the option with the higher IV than the long option. The cost and risk are less expensive than a calendar without an IV skew. This usually happens when IV levels are elevated, which in turn gives an option trader another option to consider.

Finally

Our discussion about IV levels was not overly sophisticated, but many times it does not need to be. If you understand what we covered here even a little, you are more prepared than most option traders, who do not consider implied volatility at all.

John Kmiecik, Market Taker Mentoring