Profit with Implied Volatility (Part II)

In the quest for consistent profitability, my post from March 29 (http://www.optionfanatic.com/2012/03/29/profit-with-implied-volatility-part-i/) began a series of writings that I consider to be a primer on implied volatility (IV).

Part I explained a couple things about IV.  First, IV reflects how expensive an option is.  One may plot IV over days, weeks, or months to get a sense of whether IV is currently in the lower, average, or upper part of the range.  Second, IV is driven by supply and demand.  The more demand there is to buy an option, the higher its price will become with a consequent increase in IV.  The more demand there is to sell an option, the lower its price will become with a consequent decrease in IV.

Statistically speaking, IV may be interpreted as the market’s best guess about how volatile the underlying will be in the future.  To understand this, take the IV of an at-the-money (ATM) call (or put) option in the front month with at least 14 days to expiration.  That is the projected standard deviation of price movement one year hence.  For example, if XYZ at $100/share has an ATM call IV of 30% then the market projects there to be a 68% chance of XYZ trading between $70 and $130/share one year from now.

In my next post, the IV primer will continue with discussion about how implied volatility may be used to predict earnings moves.