What is implied volatility?

What is implied volatility and how does it affect option trading? This is one concept that needs to be taken into account when learning option trading, and it's not difficult. Most of us have a basic understanding of what volatility in the stock market is - when there are crazy price swings both up and down.

Rather than cite an implied volatility definition that might include the specific calculations to arrive at implied volatility, let's go over a few concepts that should help in a complete understanding of the topic and how it relates to your trading.

One way of measuring and defining volatility is a statistical measurement called "standard deviation", which is the probability of a price moving a certain distance. The calculation is complex, but is easily shown on most options trading platforms. One standard deviation has about a 68% chance of remaining within the width of a certain move.

A variation on this is implied volatility, which can be charted on most software packages. 

Why should you care about implied volatility?

One major reason is because when trading credit spreads or selling options, you will get more for them when implied volatility is higher. A good thing to keep in mind is that when price moves up, implied implied volatility decreases. When price moves down, implied volatility increases.

When asking the question "what is implied volatility", it helps to remember that volatility implies uncertainty, and there is less concern about a rising stock market than a declining market. The higher the risk is perceived to be, the higher implied volatility becomes and the more expensive options become. This is good for an options trader when selling credit spread options or iron condors, since it results in more potential profit.

The light blue shaded area above shows one standard deviation with a put credit spread option trade. Current price of SPX is 1887, and the standard deviation area shows that there is a 68% chance that price will stay in the light blue area, above 1840, and below 1935 - almost 100 points.

In the put credit spread option trade being analyzed above, it doesn't matter how far the market moves up since there is no call credit spread option position on the upside, but the blue shaded area shows the standard deviation.

So we can see that higher implied volatility that has resulted from recent wide price swings gives us a wider range in which to be right and make more money on iron condors or credit spreads, and ultimately collect more theta as the price decays.

A practical implied volatility definition

As implied volatility increases, the standard deviation increases. Price will have to move farther before we are wrong, but by definition it also has the tendency to move farther.

In the example shown above, there is a potential $750 credit on $4250 margin for options that expire in one week. Where else could you get an 18% return like that in a week? Well, that's a function of implied volatility.

So, in what might be considered more of a practical, or functional, implied volatility definition, just remember that higher implied volatility is better when selling options, lower implied volatility is better when buying option (although outright purchase of puts or calls is something we don't do except in certain circumstances).

But remember, in the example above, the price must stay between 1840 and 1935 to be profitable. Yes, it seems like a long way to go before there would be any cause for concern, but the market can have some dramatic moves that can shake you out. One way to reduce risk even more is to go out even farther, with less credit.