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Using Current Implied Volatility For Decision-Making

Options are math. The best part about them that the many variables they are comprised of are sort of "fixed". To be specific, there is no guessing about the duration of the options (we all know how to count days), the current market price of the underlying (we all can read numbers), and the risk-free rate (this one may be convoluted at times depending on the duration of the options). The same goes for the dividend yield. The only input that can be considered "variable" is the options' implied volatility - that is, the annualized expected standard deviation of the underlying asset's returns (typically, an expected volatility in a stock's returns). Implied volatility is used by market makers to price options, which are then sold to the options' buyers. Of course, as a buyer, you have to simply accept the assumption, if you really want to buy the options. On the other hand, this is what you "charge for" as a seller - this is the "fat" on top of the options' moneyness. In other words, implied volatility is something that has to be estimated in order to reasonably price the option. In this regard, this is the only "grey" are in options pricing. Hence, you can see that options are priced pretty accurately, as opposed to stocks. The precision is not as accurate as in the case of bonds, which are pure math, but is good enough to consider them as a viable financial instrument for various purposes.

One of the most fascinating features of implied volatility is that it is mean-reversible. This means that it cannot stay too high or too low for long periods of time. Remember that stock options are essentially side bets around equities. It is...