Implied Volatility Explained: The Secret Engine of Options Pricing
Implied volatility is the level of expected volatility implied by current option prices and an options pricing model. Higher IV generally corresponds with higher option premiums, while lower IV generally corresponds with lower premiums, all else equal.
Understanding Implied Volatility
Higher implied volatility generally increases option premiums. That can make selling options more attractive, but the higher premium typically reflects greater expected uncertainty or price movement in the underlying stock. Higher premium does not automatically mean a better trade.
This means you can buy a call option, the stock can go up (in your favor), but if the IV drops significantly, the option's price can actually decrease, causing a loss.
IV Rank and IV Percentile
To understand whether a stock's current IV is high or low relative to its history, traders evaluate two metrics: IV Rank (IVR) and IV Percentile (IVP).
- IV Rank: Compares current implied volatility with the highest and lowest IV levels over a selected historical period.
- IV Percentile: Measures the percentage of historical observations where IV was below its current level.
Simple Example:
If IV ranged from 20% to 60% over the past year and current IV is 50%, IV Rank would be approximately 75%.
Formula: (50 − 20) ÷ (60 − 20) = 75%
I may consider whether implied volatility is elevated relative to its recent history, but I do not use a fixed IV Rank threshold to determine when to sell an option.
The IV Crush & Scheduled Events
Implied volatility often rises before earnings because the market expects increased uncertainty and a larger potential stock move. After the announcement, IV may decline sharply as that uncertainty is removed. This is commonly called IV crush.
IV crush can reduce option values after a major event, but it does not guarantee a profitable short-option trade. A short option can benefit from declining implied volatility, all else equal. However, the stock’s actual price move can easily overwhelm that benefit.
In my own portfolio, I generally avoid opening short options immediately before earnings. I often prefer waiting until after the announcement and reassessing the stock once the event has passed.
Company earnings are not the only events that can affect implied volatility. I also pay attention to Federal Reserve meetings, inflation reports, and labor data. These events can affect the entire market and may increase volatility across many positions simultaneously. I often prefer waiting until after major scheduled announcements before opening new short options.
IV Is Contract-Specific
Implied volatility can differ across strike prices and expiration dates. This creates what traders refer to as volatility skew and the volatility term structure. Two options on the same stock can have different implied volatility because the market is pricing different risks at different strikes and expirations.
Implied Volatility vs. Historical Volatility
Implied volatility is derived from option prices and reflects market pricing of future uncertainty. Historical volatility measures how much the underlying stock actually moved during a previous period.
The two are related but are not the same. High historical volatility does not automatically mean current options are attractively priced, and high implied volatility does not guarantee the stock will realize that level of volatility.
How I Use Implied Volatility
I look at implied volatility as one part of the options pricing environment. Higher IV may increase the premium available on a covered call or cash-secured put, but I do not select a trade based on premium alone.
I first evaluate the company and the obligation I am accepting. For a CSP, I need to be comfortable owning the shares at the strike. For a covered call, I need to consider whether I am comfortable selling the shares at the strike. IV helps me understand why the premium may be elevated. It does not determine whether I should accept the risk.
Vega estimates an option’s sensitivity to changes in implied volatility. Longer-dated options, including LEAPS, can have significant vega exposure. This means declining IV can reduce the value of a LEAPS position even if the underlying stock remains relatively unchanged. Conversely, rising IV can increase the option’s theoretical value, all else equal.
High Premium Usually Exists for a Reason
A $500 premium is not automatically better than a $100 premium. The higher premium may reflect greater volatility, an upcoming event, a closer strike, a longer expiration, or a higher probability of the option finishing in the money.
I compare the premium with the obligation and risk I am accepting. I do not chase premium simply because the dollar amount is attractive.
⚠️ This article is for educational purposes only. Options trading involves substantial risk of loss. Not financial advice.