Profit with Implied Volatility (Part I)

At the most, “option trading” and “volatility trading” are synonymous terms.  At the least, you cannot have a complete understanding of option trading without knowledge of implied volatility.  Since I can’t go too far in my discussion of options without covering this topic, I will begin today.  What follows in these posts will serve as a primer on implied volatility (IV).

I hesitate to use the S-word here, but a relatively simple interpretation of IV is how expensive an option is.  If you go to the grocery store every week and look at apples then you will develop a good sense of price in terms of range and frequency.

Consider a shopper’s hypothetical experience.  Suppose the most (least) expensive price he has ever seen for a bag of apples is $3.99 ($1.99) and usually he can buy them for around $2.69.  Today’s price happens to be $4.39.

Whether our shopper will buy apples today depends on necessity and/or market outlook.  If he absolutely must have the apples now (i.e. stop-loss) then he will pay regardless of price.  If apples are not a necessity (i.e. opening a trade) then market outlook will be his deciding factor.  If he thinks today’s price is a temporary blip and normal prices will be seen again soon (i.e. trading range) then he will not buy.  If he thinks price is just beginning to explode higher (i.e. breakout) then $4.39 is probably a bargain compared to what they will cost in the near future and he probably will make the purchase.

Like stocks, supply and demand is what ultimately drives IV.  The more an option is being bought (sold), the higher (lower) its IV will be.