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Implied Volatility 101

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Implied volatility is the most important concept and tool in options trading. It gives you a simple metric to determine how expensive or how cheap an option is relative to other similar options.

To grasp the concept of implied volatility, it helps to start with the option pricing model that started it all: Black-Scholes.

Fischer Black and Myron Scholes were a pair of quantitative types involved with some important financial theory in the 1960s. They had been working on a better way to calculate the fair value of over-the-counter (OTC) non-standardized options, those traded privately between banks and other financial institutions.

In 1973, they published an important paper with their latest theory. And that theory quickly became very applicable to the real world. Only a few months later, the Chicago Board Options Exchange (CBOE - Free Report) was founded and began trading standardized, listed equity options.

How an Option Pricing Model Works

The Black-Scholes option pricing model just had 5 basic inputs:

Stock Price: where is the stock right now?

Strike Price: price at which the option contract would grant the right to the holder to buy (call) or sell (put) the underlying stock.

Time to Expiration: how long the option contract is good for is a big factor in its potential worth.

Interest Rate: the time value of money always plays a role in financial calculations because investors have opportunity cost vs. some risk-free rate.

Volatility: what is the historical behavior of the stock in terms of price variation, expressed as annualized standard deviation, over some period of time?

When you put these components into the option pricing model, the equations produce a fair value for the given call or put.

Besides the fluctuations of the stock price and the standardized aspects of every option contract -- strike price and time to expiration -- the biggest daily variable in the changing values of option prices is the volatility input.

How Pro Options Traders Use Volatility

Professional options traders make their living based on using the “right” volatility input, which they forecast will determine an option’s value. In other words, in active trading they don’t use historical volatility as their input.

Instead, pro option traders make a forecast about volatility for a stock over a given time period.

If they raise their volatility forecast, it’s like they are saying the probability of the stock moving through more strike prices, up or down, has increased. This makes the fair value prices of options on that stock more expensive than they were before the volatility forecast was raised.

Conversely, if pro options traders lower their volatility forecast, it’s like they are saying the probability of the stock moving through more strike prices, up or down, has decreased. This, logically, makes the fair value prices of options on the stock cheaper than they were before the volatility forecast was lowered.

How do the pros decide to raise or lower their volatility forecasts? They use many decision inputs like company news, market supply and demand for options, and by considering important calendar events like earnings and other macro, seasonal, and political drivers.

Then they try to buy options that are cheaper than their forecast volatility and sell options that are more expensive than their forecast volatility.

In this way, most pro options traders don’t care if a stock moves up or down. They don’t place “directional” bets on stocks that way.

All they care about is trading the “implied volatility” of the options on a stock, buying it cheap and selling it dear.

This is a far different strategy than most speculators who are buying puts when they want to bet on a stock’s fall, or buying calls when they want to bet on a stock’s rise.

What is Implied Volatility?

So if the majority of option pros are doing something different to make money with options, it’s probably something we want to pay attention to.

To discover the all-important tool of implied volatility, we can “reverse-engineer” the option pricing model inputs to solve for volatility. We do this by using an actual option price as an input instead of a historical or forecast volatility.

We simply swap those two inputs. In the video that accompanies this article, I show a series of step-by-step diagrams explaining this in detail.

When we use an actual option price as an input in the model instead of volatility, the output is the implied volatility of the option.

In short, the option price has “implied” the volatility of the option.

And thus, we have found the price of the option in a different way that pro option traders can really relate to because it gives them an apples-to-apples basis for comparing and trading all options.

To make certain you grasp the concept of implied volatility, be sure to watch the video that accompanies this article.

And to make certain you get all my educational updates on market topics like options trading, the VIX, and technical trends, be sure to click the Follow Author button above.

Kevin Cook is a Senior Stock Strategist for Zacks Investment Research where he runs the Tactical Trader portfolio.