Implied Volatility
- Thread starter isoroi
- Start date
I 'think' its coming together now.
Please assess my enlightened understanding with my summary below.
I do a lot of covered call selling. I have a screener that I use that points out high return option plays. It does not give me the IV. I was falsely interpreting the high premium as a measure of that option's volatility. The IV would be useful in determining which options are more likely to move before expiration. This would give me the opportunity to better gauge risk/reward.
Quote from isoroi:
I 'think' its coming together now.
Please assess my enlightened understanding with my summary below.
I do a lot of covered call selling. I have a screener that I use that points out high return option plays. It does not give me the IV. I was falsely interpreting the high premium as a measure of that option's volatility. The IV would be useful in determining which options are more likely to move before expiration. This would give me the opportunity to better gauge risk/reward.
Higher premium does mean greater volatility, but premium also depends on expiration and stock price. An IV chart gives you a better picture of what happened to option premiums in the past. For example, you may find an option with huge premium and when you look at IV you find that the option is trading at 200% IV, and when you look at an IV chart to see where this 200% is in relation to past levels you find that the average over the past 1-2 years has been 40%. You also notice that the same strike call, but in the next expiration month is trading at 45% volatility.
So what does that tell you? It tells you that the market expects a significant move in the stock price prior to the first call's expiration (it is common to see such pattern in biotech stocks where there's an FDA hearing coming). In other words, the higher premium is there for a reason. That is, higher probability of significant move. The risk/reward is proportional.
Looking at IV from various angles gives you a better picture of what the market expects in terms of future volatility without the need to use an option pricing model. That is, all the other variables are either the same or fixed, the only unknown is the volatility.
Quote from isoroi:
I 'think' its coming together now.
Please assess my enlightened understanding with my summary below.
I do a lot of covered call selling. I have a screener that I use that points out high return option plays. It does not give me the IV. I was falsely interpreting the high premium as a measure of that option's volatility. The IV would be useful in determining which options are more likely to move before expiration. This would give me the opportunity to better gauge risk/reward.
A couple things to point out. Some might think that it is a matter of semantics, but I think if you're learning this you should have the right perspective on it.
An options price yeilds an "implied volatility", and not the other way around. People often say that one option has a higher premium because the IV is higher (ceteris paribus). This is backwards. The IV is higher because the premium under the same conditions is higher. That is why it is called "implied" volatility. It is what the future volatility must be (given the time left till expiry) to justify the current market price of a given option.
Current market sentiment determines a given option's value and the IV is the result. The price of the underlying and time till expiry are not debatable, they are fact. Thus to justify a higher market price you also need to "imply" a higher volatility, or greater chance that the option will expiry in the money.
As far as your use goes. Your primary concern should be finding a stock that you think is not likely to drop. Covered calls actually provide little protection in the event of a big drop in the underlying, and unless you buy back th calls at a loss, you can't sell you stock position to cut losses. You want to find a stock that you think will either stay put, or go higher. The premium received for selling the calls is secondary.
One nice cioncidence is that volatility generally rises as a stock falls. So a quick decline to a strong support might often get you a better premium. All things you must consider.
I like this statement and make this point to people all the time.
Many people subscribe to the efficient markets theory. The basic assumption is that all securities are priced efficiently, including options. I don't fully buy into it. As far as I'm concerned, an option is ALMOST NEVER priced correctly. The only time that it is priced correctly is when the IV at the time of purchase matches the actual volatility from the time of purchase till expiry. This is exceptionally rare.
The real question is whether you can more frequently predict (or guess) whether the actual volatility will be higher or lower than the current implied vols.