Implied Volatility vs. Stock Volatility

When buying or selling options, you should be aware of the implied volatility of the option because it plays a significant role in determining of the option's price (premium).

Here's an example:

Consider an option with 6 months until expiration and a strike price of 50:

• If the implied volatility is 90, the option is worth  $1250
• If the implied volatility is 50, the option is worth    $725
• If the implied volatility is 30, the option is worth     $450

Implied Volatility vs. Stock Volatility

The stock volatility is a measure of how volatile the stock had been in the past. This volatility can be calculated with great accuracy because it depends on a statistical analysis of real closing prices for the stock. There is no disagreement among traders on the value of a stock's historical volatility.

The implied volatility is the marketplace's current best guess for how volatile the stock is going to be in the future - specifically, from the current time until the option expires. The future volatility can never be known, and must always be estimated. Because the option premium is so dependent on implied volatility, it's common for different traders to disagree on the value of an option. Thus, some traders buy options because they think they are inexpensive, while others sell the same option at the same price because they believe it to be expensive.

The important point for you to understand is that implied volatility rises when the company is expected to issue news, such as an announcement of the quarterly earnings, or an FDA announcement regarding the results of a pharmaceutical company's clinical trial for a new drug. Under those conditions, it's more likely than normal for the underlying stock to undergo a significant price change, and thus, people are anxious to own calls and/or puts. At the same time, it becomes more risky for traders to sell those options. As a consequence, demand is greater than supply and option prices rise. And they often rise by large amounts. The innocent option rookie who comes along to buy some options just ahead of such a news event has no idea that options are priced high and buys options (calls for example), sees good news and a subsequent rally in the price of the stock, and is shocked to discover that the price of the call options has decreased.

Why does that happen? Once the news is out, there is no longer any expectation that the stock will make another significant move. Few people are interested in buying options and instead, all of yesterday's buyers become sellers. Under those conditions, supply exceeds demand and prices fall.

If you ever plan to buy options, be aware of the implied volatility, and if it's abnormally high (compared with the recent implied volatility of these options), it's better to avoid buying the options. There are alternative strategies you can adopt (see The Rookie's Guide to Options), but please understand that buying options becomes riskier than ever when implied volatility is high.

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