Why Implied Volatility Is King For Options Traders

In the world of option pricing, implied volatility is king. Its importance is paramount as its behavior can have substantial ramifications on a trader’s bottom line. An option’s price, like any tradable security, is driven by supply and demand. Implied vol is a handy metric allowing traders the ability to gauge the supply/demand status of an option.

When demand outstrips supply, implied vol will lift.

When supply outstrips demand, implied vol will fall.

You may notice the term “price” could be interchanged with “implied vol” in the prior two statements.  Rather than being a mere coincidence, this speaks to the direct relationship between an option’s price and implied volatility. Namely, when all variables are held constant (stock price, time to expiry, etc…), a rise in an option’s price will result in a rise in implied vol. The following diagram aids in illustrating the relationship.

A surge in demand for options can sometimes lead to unjustifiably high prices which, in turn, spell opportunity for option sellers. Indeed, some look at this as the ideal time for option sellers to strike. The additional risk premium pumped into an option’s value allows sellers the ability to rake in additional dollars which not only serves to increase the potential return, but also enlarge the profit zone.

Familiarizing yourself with the normal ebb and flow of implied vol is an endeavor worth both the time and effort.  Whether you keep it simple and focus on broader market volatility gauges like the CBOE Volatility Index (VIX), or hone in on individual vol charts provided by the likes of www.ivolatility.com and www.livevol.com, or even go as far as learning the intricacies of vol skew, the process will be a key stepping stone in your ascension to trading profitability.

Guest Post by Tyler Craig www.tylerstrading.com