What trader has not experienced dramatic moves in option prices within a few short minutes during a trading day? Or maybe the market moved in favor of your position but your option still lost value? All of these can be summed up in one word: VOLATILITY
What Drives Volatility?
Before we get into some more details, you have to understand that human emotions are the biggest driver of market volatility. Realizing emotions play a large role in stock market activity is a critical step in successful investing. Not only is your ability to recognize a few significant emotions, both in yourself and in other investors/the market, but your ability to recognize when volatility is relatively high will help increase your trading profits.
For simplicity’s sake, the typical market emotions by all investors are:
What Do I Need To Know About Implied Volatility?
As option traders we measure how expensive or cheap options are using a parameter called implied volatility, or IV for short. This one data point helps uncover what time of emotional tendencies are in the market. High IV is synonymous with expensive options and thus shows that there is a lot of fear in the market which is driving up prices due to increased risk. Low IV is synonymous with cheap options and shows either complacency and/or greed in the market. Investors are not adequately accounting for risk and therefore the markets seem “calm” just before the storm.
How Can I Use IV To Make Better Trades?
Generally, being the sophisticated traders that you are, you will naturally want to take advantage of implied volatility each month. When IV is low then you want to favor buying options. When IV is high you want to favor selling options.
Remember the example from above where the market moved in the right direction of your trade but you still lost money? This is most likely because you bought an option when IV was extremely high. And although the market moved just as you thought, you still lost money because you paid too high a price for that option.