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Options Q&A: How do I determine if implied volatility of an option is high or low?

Attempting to trade around implied volatility shares some similar aspects to trading around stock price. Many times it will continue to oscillate up and down, without a definitive signal to indicate which way the volatility will move at any given time. So, just like in trading stocks, an important question to ask is, "Is the volatility right now higher than it should be? Or is it lower than it should be?"

To answer this question, traders will study historical patterns in volatility as well as any news that could impact it down the road, just like a trader might research the fundamental data and market history of a stock price.

Traders look at how volatility for the underlying asset behaved in the past. At MarketChameleon, we like to use two different measures of historical volatility to compare against the current market.

The first is historical stock volatility. If you look on the overview page for a certain ticker, for example, IBM [https://marketchameleon.com/Overview/IBM/], you'll see under the "Volatility" section at the top a value for Today, 20-Day, and 52-Week. This is the historical stock volatility, measured using the Open-High-Low-Close calculation. This volatility is annualized -- meaning it represents the expected volatility for a stock if it were to keep up the same patterns for a full year. In this example, IBM has a 20-Day historical volatility of 18.5 and a 52-Week historical volatility of 17.6.

The second benchmark is historical implied volatility. To measure this, we record the 30-Day Implied Volatility (IV30) at the end of each day, and take an average of those values over the course of an entire year. For example, the IBM 52-Week average IV30 is 19.3.

We uses these benchmarks to set baselines for the current market. If you look at the option market for IBM today and see that its implied volatility is 25.0, that would suggest a much higher value than these historical means. Typically, we expect that volatility will revert back towards historical values, but there are some cases when it might not be accurate -- if there is important news coming out on the stock, or an earnings release in the near future, implied volatility can be high because the market is anticipating increased fluctuation.

Stock prices can slowly and steadily increase over time, or slowly and steadily decrease over time, but that pattern is unlikely to be followed in volatility. Volatility is a measure of how much a stock price moves, not just the direction in which it moves. For volatility to continually increase over time, the stock price would have to vary more and more as time goes on.

For this reason, a trader would not simply purchase options to hold indefinitely in hopes that volatility will continue to rise, the same way one might hold a stock. Volatility movements tend to be cyclical, and options traders make bets on volatility in shorter time frames. If they sell options that are trading at a high volatility, the expectation is that the stock will revert back to historical averages, and the trader will profit on the difference.

One final reminder about the assessment of a stock's volatility -- when determining whether the volatility is high or low, it's important to compare against historical markets for that asset. Broad-market ETFs and utility stocks, for example, tend to have low volatility -- somewhere in the range of 10 to 20. Healthcare stocks or technology companies might have higher volatility in general, 50 or 80 or 100. So just because a stock might have an implied volatility of 15 doesn't mean that it is low -- if the historical benchmarks we mentioned above are 10 or 11, that 15 could very well represent volatility that is too high. And likewise, it is possible that a ticker that is trading at a volatility of 90 could be considered low, if it has been shown in the past to average 110.

Posted from the original: https://marketchameleon.com/Blog/post/2016/11/23/options-q-and-a-how-do-i-determine-if-volatility-is-high-or-low