Warrior Trading Blog

Implied Volatility Definition: Day Trading Terminology

Implied Volatility

Options are a way for investors to get involved with the markets even if they do not have that many funds to get started. Many investors are hesitant to get involved with options because they seem too complicated.

However, with just a little education on these it becomes a lot more clear.

There are benefits to using options as part of an overall investing strategy. One factor to understand about them is something known as implied volatility.

Implied Volatility is an important part of  how options are priced and something every option trader should understand how it works. It is a critical variable that must be examined by an investor to ensure that they are getting a good price on their option.

Options are purchased on the expectations that a stock will move up or down in a given period of time.

The bigger the movement in the right direction, the more that the investor can profit. With options more volatility in the stock is a positive thing.

Time Decay

If the stock moves dramatically, then the price of the option will move accordingly. This is important because there is always something known as a “time premium” attached to the option.

This is a value added to the option because there is time remaining before it expires. As the expiration date nears the time premium starts to evaporate away.

Given this, the investor will need to see their option increase in value more than the time premium evaporates away.

With this goal in mind, it is nice to have high volatility in a stock. It means that the price will increase enough to overcome the time premium problem. Every option will show the implied volatility number next to the corresponding option.

The higher the number the better. Keep an eye out for this number and consider how it might impact the price of the option.

If there is value in making the purchase then take the dive and go for it.

Warrior Pro Tip

Implied Volatility

The important thing to remember with implied volatility is that when it increases, so does the option price and vice versa. So one strategy option traders use is to buy options ahead of an important announcement like earnings.

Options will usually increase up to the announcement because implied volatility will be increasing which will help your position.

As you can see in the IV chart above, there are spikes in IV as prices as it gets closer to earnings release and then drops after they’re made public.

That is why you can lose money on earnings plays even if it goes your way because all of the volatility is being sucked out the premium, which is also known as a volatility crunch.