How is Implied Volatility taken into consideration in your option plays? (July 8, 2003)
Implied volatility is a component of option pricing along with the time until expiration, whether the option is in, at, our out of the money, etc. What implied volatility tries to do is assign a value to the assumed range of movement a stock might have during the life of the option. There are two methods of calculating implied volatility, and we will not go into the details here. Basically the more volatile a stock is and the wider its potential trading range, the higher the implied volatility component and the more you will pay for the option. That is one reason it is hard to buy options on news as the volatility element jumps up and you pay more for the option. As soon as the news is no longer news, volatility dies down and your option can lose value even if the underlying stock holds steady.
When looking at options for our plays we look to see if there are options with lower volatility vis-a-vis historical levels. In other words, we look to see if the option is trading higher or lower than its historical volatility. If you can find them and they are reasonably near the strike and time you want, then you can get better value and more bang for your buck with them because you are not buying an option inflated with higher volatility. Indeed, implied volatility has been lower after the market sell off though with the srong moves of late it ahs been creeping back up. We try to get lower volatility options, but that is not always possible as there is news or expectations growing with respect to a stock. Still, if we like the play enough we will still look at options for the play if we the return will be sufficient if the play makes the move we want.
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