Implied Volatility (IV) measures the anticipated volatility of the underlying asset of an options contract. Not to be confused with historical volatility, which is backward looking based on the completed moves of the underlying stock, IV is a forward looking projection of price ranges.
An increase in Implied Volatility leads to inflated options premiums. We can track the potential effect of change in an options contract’s IV with the greek vega, which projects the price change of a contract based on a 1% change in the IV. If an option contract has a vega of .08 and the IV increases 10%, traders could anticipate the contract to gain $80 in value from the IV increase alone.
Unpredictable market events, or anything that casts uncertainty, increases IV. A perfect example would be an options contract on a company that has an earnings report scheduled before the contract's expiration date.
BYND is set to report earnings on May 12th. The contracts expiring on 5/6, the week before earnings, have an IV of about 94%. The contracts expiring may 13th, a day after earnings, have an IV of about 122%.
With a vega of .03, we can calculate that the market is pricing in earnings volatility of about $114. We know this because the IV on earnings week contracts is 38% higher than the IV of contracts expiring prior to earnings. 38% x (.03 x 100 shares within the contract) gives us our increased volatility pricing of $114.
A decrease in Implied Volatility leads to deflated options premiums. If an option contract has a vega of .08 and the IV decreases 10%, traders could anticipate the contract to lose $80 in value without the underlying asset even moving. An options contract’s IV suddenly decreasing and slashing the contract’s value is referred to as IV crush. This is why it is important to stay vigilant in assessing if an option contract has an inflated IV before executing a trade.
Ideally, traders should look to buy contracts with low IV and sell contracts with high IV. So how do we determine if a contract has low IV, and how can we predict when IV could spike?
When demand diminishes in an asset, or when there is a lack of unpredictability in the market, IV decreases. This is most common when price action fails to live up to the expectations of the market. Times of consolidation and low volume are also indicators of decreasing IV.
The green line on the right chart is TSLA’s IV for the current trading session. We see IV trending down through the entire session. This is very common when considering volume generally peaks in the first hour of market open, trending down the rest of the day (barring any unexpected news catalysts that attract volume). For this reason, many swing traders wait until right before close to enter an overnight position to avoid taking a hit on theta and IV crush through the trading session.
As an options day trader, the goal is to catch stocks toward the start of volatility spikes. The best way to do this is a combination of directional indicators such as technical analysis, options flow, and darkpool data.
Institutions often strategically build options positions with size in anticipation of a volatility spike. Identifying Unusual Options Activity will allow you to confirm your favorite trade ideas with the confidence that big money's sentiment aligns with yours, or even discover new ideas based on what they're trading.
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