Implied Volatility -> Its Effect on Option Premiums

One of the ways an option premium is priced is due to implied volatility.

Implied volatility basically shows the expected volatility of a stock over the life of the option.  As a stock’s price changes the option premium (cost) moves accordingly.

Implied volatility increases with uncertainty.  It also increases in response to an upcoming big event (such as earnings report), the supply and demand of the underlying option and by the expectation of the share price's direction.   Implied volatility decreases after these types of events.

As expectations surrounding the stock arise or demand for an option increases; implied volatility will also rise. Options that have high implied volatility will result in high-priced option premiums.

Options that have lower implied volatility levels because of low demand will have lower priced premiums.  This is important because the rise and fall of implied volatility will determine how expensive or inexpensive premium values are in relation to the option.

A trader can use this to their advantage by examining a volatility chart (some platforms have this ‘stat’ listed so one can consider the relative highs and lows of the average volatility prior to their trade).

One of the ways I determine the “less expensive” option premium entry is to look at a chart with volatility bands on the stock price.   See below….

The area where the bands tighten show a basing or quiet period which should reflect  lower implied volatility and therefore lower premiums. This is where the trader should consider ‘buying strategies’ for options. Conversely as volatility increases, as shown by expanding bands and higher implied volatility levels, the trader should consider ‘selling strategies’ such as credit spreads for income.

The trader, when studying option strategies, expiration months or strike prices, should also consider the impact that implied volatility has on their trading decisions to make the most profitable choices.