Aligning Your Options with Implied Volatility

August 28, 2023 Advanced
Learn the difference between implied and historical volatility and find out how to align your options trading strategy with the right volatility exposure.

Implied volatility (IV) is like gravity. You can't directly observe it, but you know it's there, and it's measurable. And it's pretty important too. Just as gravity impacts our daily lives, implied volatility is an essential ingredient in options pricing. And "what's priced in" can be a key factor in determining the outcome of an options trade.

Implied volatility

Expressed as a percentage, implied volatility (IV) is computed using an options-pricing model and reflects the market's expectations for the future volatility of the underlying stock. For example, if the IV of XYZ 30-day options is 25% and similar options on ZYX have IV of 50%, ZYX shares are expected to see greater volatility than XYZ shares over the next 30 days. IV can change often and will vary from one option to the next, even when the options are on the same underlying stock.

All else equal, the higher the IV of an option, the higher the options premium, and therefore a bigger expected price change in the underlying stock. There's one major caveat, though: IV doesn't say anything about the direction of the move, just the magnitude and probability. For a graphical representation of the probabilities for an underlying stock's potential moves, traders can use a probability cone on thinkorswim® (see image below).

To view a probability cone on thinkorswim, select Probability Analysis under the Analyze tab. A probability cone uses IV to depict a range of potential price outcomes for a specific level of volatility. The example stock below, with IV at 26.21%, is showing a 68.27% chance the price will land within the range of the cone at each future date. Why 68.27%? Under a normal distribution, 68.27% of observations fall within one standard deviation of the mean. But the probability range can also be adjusted to show probabilities based on two or three deviations.

Probability analysis

A probability cone illustrating the range of probability of reaching various stock prices assuming a one standard deviation move over different expirations.

Source: thinkorswim platform

Historical volatility

Sometimes referred to as actual or realized volatility, historical volatility (HV) is a measure based on a stock's daily price moves over a specific time frame, such as 20, 30, or 50 days. While IV reflects future expectations, HV looks backward. Comparing HV and IV can be a useful way to understand how much expected volatility is being priced into options versus how volatile the stock was in the past (see image below). Keep in mind, however, past performance doesn't guarantee future results.

All else equal, higher IV relative to HV might suggest options are expensive, while lower IV might suggest options are inexpensive. However, because markets are forward-looking and relatively efficient, disparities between IV and HV are not necessarily a sign that options are mispriced. Rather, the high or low IV could potentially reflect market expectations that the volatility of the underlying stock might be different going forward than it was in the past.

Historical vs. implied volatility studies

As a stock moves up and down, implied volatility and historical volatility ebb and flow.

Source: thinkorswim platform

The meaning of mean-reverting

Implied volatility can sometimes display a mean-reverting tendency, suggesting there are periods when it strays from its previous average and then returns (or reverts) back to the average, or the mean.

The IV of an option may deviate from its previous average ahead of stock-moving events, including earnings announcements, important economic data, Federal Reserve meetings, or company-specific news like a ruling on a new drug, a new product announcement, or a shareholder vote on a merger or acquisition.

Recognizing when IV is at an extreme level relative to its historical average can help identify events that might potentially move the underlying stock price, and it can sometimes help in strategy selection as well. For option traders who suspect a stock's trend reversal in the future, IV levels would likely be a secondary consideration but could influence the choice between buying and selling. In general, when the IV of an option is high and falling, some traders might consider shorting an option to gain negative exposure to volatility. Conversely, if the IV of an option is low and rising, some traders might consider going long an option to gain positive exposure to volatility.

For example, in periods of high IV, some traders consider selling strategies like covered calls1, cash-secured2 or naked puts3, or credit spreads4. On the other hand, for periods of low IV, some traders consider buying strategies like long calls or puts or debit spreads5.

Whichever options strategy you select, you can potentially enhance a trade by aligning a directional opinion with volatility expectations. At the very least, comparing current IV to past IV (and historical volatility) can potentially help a trader better understand whether the market is implying an increase or decrease in an underlying stock's future volatility.

1A limited-return strategy constructed of a long stock and a short call.

2A strategy that involves selling a put and holding enough cash in the account to acquire the underlying stock if assigned on the put option.

3A position in which the writer sells put options and does not have the corresponding short stock position or enough cash deposited to cover the exercise of the put.

4A spread strategy that increases the account's cash balance when established. Selling a call and buying a call with a higher strike price in the same expiration or selling a put and buying a put with a lower strike price in the same expiration are examples of credit spreads.

5A spread strategy that decreases the account's cash balance when established. Buying a call and selling a call with a higher strike price in the same expiration or buying a put and selling a put with a lower strike price in the same expiration are examples of debit spreads.

Just getting started with options?

Today's Options Market Update

Stocks are lower across the board as investors grapple with rising yields.

Trading Covered Calls & Short Puts

In this webcast, your education coach will discuss how and when some options traders might employ the covered call strategy in their income portfolios. Expect a balanced education on the potential benefits and risks of this strategy, and explore the tools that can help you implement it.

Getting Started with Options

This webcast is carefully structured to help new option traders along the leverage learning curve. Your education coach will introduce you to options terminology, clarify the common opportunities and risks, and explain the associated rights and obligations to help you become more confident with your understanding of options trading.

Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the Options Disclosure Document titled "Characteristics and Risks of Standardized Options" before considering any options transaction. Supporting documentation for any claims or statistical information is available upon request.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received.

With long options, investors may lose 100% of funds invested.

Commissions, taxes, and transaction costs are not included in this discussion, but they can affect the final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.

Uncovered options strategies involve potential for unlimited risk and must be done in margin accounts.

Spread trading must be done in a margin account. Multiple leg options strategies will involve multiple commissions.

Investing involves risks, including loss of principal. Hedging and protective strategies generally involve additional costs and do not assure a profit or guarantee against loss.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

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