Trader Q&A: Implied Volatility, Demystified

If you feel lucky enough to "trade against known odds and probabilities," you can stop reading now. Everybody else: This email is for you. [Schaeffer's Logo]( Dear Trader, OK, let's get right into it -- today's email is about implied volatility. Perhaps no topic strikes greater fear and anxiety in the hearts of options traders... and hey, we get it. Unexpected spikes and crashes in implied volatility (IV) can play havoc with option prices, and drastically change your trade outcomes -- regardless of whether the underlying stock or ETF is little changed, or even moving as you expected. But the more you know about IV, the less intimidating it becomes (and, as a bonus, the more qualified you'll be to get into debates about arcane Cboe Volatility Index quirks on Finance Twitter). So, to demystify this "wild card" factor that affects all of your [option trades]( here are the answers to some of your top volatility FAQs, courtesy of Schaeffer's Senior Quantitative Analyst Rocky White and Schaeffer's Quantitative Analyst Chris Prybal. What is implied volatility (IV)? Prybal: IV measures the market's expectation for the volatility of an underlying stock during an option's lifetime. Knowledge of IV is especially important for option investors, as it is factored into an option's price. Or, in simpler terms, IV can provide clues to as to whether an option is "a bargain," on a relative basis. High IV is typically associated a higher level of uncertainty as to which direction the underlying equity will move, and it's also associated with a higher cost of entry for option buyers, and a higher premium collected for sellers. Conversely, low IV indicates relatively muted expectations for the stock's future price action, and is generally associated with lower premiums. How can you gauge whether IV is running high or low for a particular stock's options? White: Here at Schaeffer's, we have our own internal IV annual range calculations (based on the Schaeffer's Volatility Index), which allow us to compare current IVs to that of the past year. We can also tailor this calculation to go back further in time for emphasis or statistical usage. There are also some subscription data programs that offer historical range data for comparison. Broadly speaking, you can expect equity IV to pick up around known events, conferences, announcements, earnings, major news headlines, and big bearish stock moves. What does Schaeffer's Volatility Index (SVI) measure? Prybal: SVI is meant to reflect the short-term IVs on a stock's options. It always uses the front-month standard expiration, and finds the at-the-money IV for that series. But once the front-month expiration is within a week, the SVI calculation rolls to the next month, because IVs can get pretty unstable the closer you get to the expiration date. In addition to the raw SVI number, we place each daily SVI reading within the context of an annual percentile. This allows us to determine, at a glance, whether front-month IVs are running relatively high or relatively low for a particular stock. Which options strategies would you consider employing when IV is high? White: Premium-selling strategies -- such as covered calls, put sells, and credit spreads -- allow you to use the elevated IV to your advantage, since these tactics involve a maximum potential profit that's collected upfront. In that sense, the high IV effectively "pads" your premium collected. Bear in mind that IV is ultimately mean-reverting, given enough time, so it's generally likely to deflate again after a big surge higher. Which options strategies would you avoid when IV is high? Prybal: Premium buying, whether calls or puts, is much more difficult with elevated levels of IV. As noted earlier, elevated IVs are usually the result of a newsworthy event or highly volatile price action. An investor can be right on picking the direction of a stock's move in these situations, and still lose on a corresponding options trade because IVs have collapsed after the event passes, which reduces the overall premium of the option (net-net of any directional movement). This is known as a "volatility crush," and in this situation, you need the price movement to substantially outweigh the IV plunge in order to turn a profit. Due to this challenge, it is often difficult to make money by buying options which carry higher IVs. Are there any recent examples where you have used IV to make a successful trade? White: We recently made a 153% profit on Crocs (CROX) calls in our Weekend Trader Alert service. As we told subscribers at the time of the recommendation, "The stock's Schaeffer's Volatility Index (SVI) of 42% sits in the 9th annual percentile, revealing low volatility expectations being priced into near-term contracts. Our recommended December 17 call currently sports a leverage ratio of 4.3, and will double in value on a 22.4% gain in the underlying security." [Learn More]( Is there ever a time where IV isn't a consideration in your trade research? Prybal: Monitoring IVs and successfully trading the movement of IVs is second only to monitoring price action. It is always a useful metric, and never to be avoided unless one wants to trade against known odds and probabilities. Today's the Day You Start Profiting from Volatility. Are you ready to start turning Wall Street's fear and anxiety into your own powerfully profitable trading opportunities? Schaeffer's Weekend Trader Alert is the ideal way to make sure you'll never overpay for implied volatility, since each trade recommendation is pre-screened for its affordable premiums and optimal leverage ratio before it ever leaves our trading desk. Every Sunday at 7 p.m. ET, you'll receive a new options recommendation straight to your inbox. Each pick will be accompanied by an easy-to-understand commentary where you'll learn what the investing crowd is expecting from the stock -- and why we think they're in for a surprise during the weeks and months ahead! And you'll never have to worry about the details, because we provide everything you need to manage the trade, including a target profit and time-stop date. You're never left wondering what to do -- we'll guide you every step of the way! As a special "thank you" for choosing Schaeffer's, we're offering a special deal on Weekend Trader Alert right now. You can take advantage of our powerful full-service recommendations at a special savings off our usual price -- but only for a limited time! While a month of Weekend Trader Alert typically retails for $149, as a special VIP gift, we're offering you your first month for just $10! Yes, really! That's a full month of these fan-favorite trades for just $2.50 per trade - but only for select subscribers! [Click here to claim your place]( and see for yourself how the power of options can transform your portfolio... but remember, this offer is only open for a few days! [Act Now]( All my best, Bernie Schaeffer Chairman & CEO Schaeffer's Investment Research service@sir-inc.com []( 1-800-448-2080 1-513-589-3800 International P.S. Don't overpay for implied volatility! [Buy low and sell high with my low-IV Sunday night trades.]( 5151 Pfeiffer Rd Cincinnati, OH 45242 If you didn't create an account using this email address, please ignore this email or [unsubscribe](. To ensure delivery of this email to your inbox and to enable images to load in future mailings, please add enews@schaeffer.com to your e-mail address book or safe senders list. Although there is significant profit potential associated with buying options, there is also the risk of losing one's entire investment in any individual trade. In any option buying approach, it is expected that losing trades will be more numerous than winning trades. The goal is for the average gain to be significantly greater than the average loss so that the bottom line is profitable. Prior to purchase, ensure that you have a broker that allows the trading of options and that you are approved to trade options.