The most misunderstood component of options pricing is implied volatility. Successful options traders understand that implied volatility is the key “ingredient” to making proper trading decisions when buying and selling options and options spreads. Volatility in regards to options is measured two fold. The first and most easily understood is called Historical or Statistical volatility. Statistical volatility simply is the volatility of a financial instrument based on historical returns. Statistical (historical) volatility as the name implies, refers to past actual data.
Implied volatility on the other hand refers to a future expectation of price fluctuation. The higher the implied volatility the more one could expect the stock or underlying instrument to move in either direction. Conversely, the lower implied volatility references a more stagnant underlying instrument. This implied volatility is an extremely important component of options pricing and its effect on an options price is what makes an option either “cheap” or “expensive”. Rising implied volatility makes options more expensive and conversely decreasing levels of implied volatility makes options less expensive.
Of all the inputs that go into pricing models such as the Black-Scholes options pricing model, implied volatility is the only variable component. The other components of the pricing model are exercise (strike) price, the riskless rate of return, time until expiration, and the price of the underlying. Implied volatility (variable) is determined by the market maker and is based on the public’s expectations of upcoming events that may change the ultimate value of the options contract. Market makers who are charged with making a market for these instruments increase and decrease implied volatility to increase or decrease the price of the option. The other components mentioned above are all factual and are not based on subjective interpretation.
Because of what I just mentioned above, sharp traders realize that money can be made in strategies that exploit the expected moves (or lack of movement) in implied volatility. There are many strategies that can accomplish this but the general rule of thumb is that if your expectation is for decrease in implied volatility, then being a seller of an options contract would behoove you . Conversely the opposite would apply; being “Long Vega” or buying volatility would benefit the trader who believes implied volatility is set to rise.
