If you trade options, you will hear about implied volatility all the time. It is one of the most important concepts to understand because it directly affects how much you pay for options. Let us break it down simply.
What is Implied Volatility?
Implied volatility (IV) is the market's prediction of how much a stock's price will move in the future. It is "implied" because it is calculated from option prices, not from the stock itself.
Simple version: High IV means the market expects big price moves. Low IV means the market expects small price moves. Options are more expensive when IV is high.
Why Does IV Matter?
IV directly affects option prices. Here is why that matters:
- High IV = expensive options: You pay more to buy calls and puts
- Low IV = cheap options: You pay less for the same options
- IV can change: Even if the stock price stays flat, your option can gain or lose value based on IV changes
Example
Stock ABC is at $100. A $105 call costs $3.00 when IV is at 30%.
Before earnings, IV jumps to 60%. That same $105 call might now cost $5.00 even though the stock has not moved.
After earnings, IV drops back to 30%. The call drops back to $3.00. This is called "IV crush."
What Causes IV to Change?
- Earnings announcements: IV spikes before earnings because the market expects a big move
- News events: FDA decisions, product launches, lawsuits
- Market uncertainty: During market crashes, IV rises across all stocks
- Time: IV tends to be higher for longer-dated options
IV Crush Explained
IV crush happens when implied volatility drops suddenly. This usually occurs right after an expected event like earnings.
Even if you predict the direction correctly, IV crush can still cause you to lose money. This is why buying options right before earnings is risky.
How to Use IV in Your Trading
For Option Buyers
- Buy options when IV is low (they are cheaper)
- Avoid buying right before earnings unless you account for IV crush
- Look at IV percentile to see if IV is high or low historically
For Option Sellers
- Sell options when IV is high (collect more premium)
- Selling before earnings can be profitable if IV crushes
- High IV environments favor credit spreads and iron condors
IV Percentile and IV Rank
Raw IV numbers do not tell you much. A 40% IV might be high for one stock and low for another.
- IV Percentile: Shows what percentage of days had lower IV. An IV percentile of 80% means IV was lower 80% of the time over the past year.
- IV Rank: Shows where current IV falls within the range of IV over the past year.
Common IV Mistakes
- Ignoring IV before buying: You might overpay if IV is elevated
- Not accounting for IV crush: Your option can lose value even if you are right about direction
- Comparing IV across different stocks: Each stock has its own normal IV range
Track Your Options Performance
Pro Trader Dashboard tracks all your trades and helps you understand how IV affected your results.
Summary
Implied volatility is the market's expectation of future price movement. High IV makes options expensive, low IV makes them cheap. Understanding IV helps you avoid overpaying for options and take advantage of IV crush. Always check IV before entering a trade.
Learn more about options Greeks or read about theta decay.