Options Implied Volatility (IV)

Implied Volatility forms one of the significant components of an option's premium(the price of an option)

Implied Volatility (IV) is simply a measure of the current level of risk of a stock option. It is sometimes compared with its historical volatility (HV) to determine whether this level has risen or has been down lately. Naturally, when IV is high, an option premium is higher (since it has a higher probability of going into-the-money) and when IV is lower, the option premium is cheaper. But IV is only part of the option premium component, the option's premium can still be affected by other components like share price, strike price, time until option expiration, interest rate, dividend yield.

You can verify any options implied and historical volatility at The Chicago Board Options Exchange.

What would cause the implied volatility of an option to increase? Usually it's due to an anticipated event which is going to affect the stock price very significantly in the near future. This event could be an upcoming earnings or guidance announcement, a potential takeover bid, upcoming FDA results for a company's drug submission etc. The implied volatility of the stock option, whether it's a put or call, would gradually increase as the significant event draw nearer.

You might be puzzled why you have bought a call option on the eve of an event announcement, the outcome turned out to be positive and the share price subsequently moved up a few points but your call option still lose money. This was because usually after an event has occurred, the option's implied volatility would return to its normal value after reaching an extreme (known as mean reverting) and the option premium would drop dramatically due to this reduction in implied volatility. The only way for this option position to be profitable would be if the stock price made a substantial price movement in your anticipated direction and the stock option you've bought gained plenty of intrinsic value. Don't forget that your option premium would also have time value if there's still some time before expiration.

There are options traders who would buy an option a few days before the announcement of an anticipated event and would quickly sell them on the eve of the announcement because the implied volatility would usually be inflated towards the announcement date & options premium would be highest during that time. That is why you sometimes hear about buying options when implied volatility are low and selling them when implied volatility are high.

It is important to do some research to find out why a stock option has sudden built-up of implied volatility. A little investigation would prevent you from suffering losses buying/selling stock options at the wrong price and at the wrong time.

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What Is Options Trading?

An option contract is an agreement between two parties to buy/sell an asset (In this case, the asset refers to stock) at a certain price and specific date.
It is called an option because the buyer is not obliged to carry out the transaction. If, over the life of the contract, the asset value decreases, the buyer can simply elect not to exercise his/her right to buy/sell the asset.
There are two types of option contracts - Call options and Put options. A Call option gives the buyer the right to buy the underlying asset, while a Put option gives the buyer the right to sell the underlying asset.

A simple example: Peter buys a Call option contract from Sarah. The contract states that Peter will buy 100 Microsoft shares from Sarah on the 5th May for $25. The current share price for Microsoft is $30.

Note: this is an example of a Call option as it gives Peter the right to buy the underlying asset.
If the share price of Microsoft is trading above $25 on the 5th May, then Peter will exercise the option and Sarah will have to sell him Microsoft shares for $25. With Microsoft trading anywhere above $25 Peter can make an instant profit by taking the shares from Sarah at the agreed price of $25 and then selling the shares on the open market for whatever the current share price is and making a profit.

The $25 value, which is stated in the agreement, is referred to as the Exercise (or Strike) Price. This is the price at which the asset will be exchanged.
The date (in this case 5th May) is known as the Expiry (or Maturity) Date. This date is the deadline for the option contract. At this date, the option buyer is to decide if a transaction of the underlying asset is to occur.

Outcomes: Let's imagine that at the expiration date, Microsoft is trading at $30, then Peter will buy the shares from Sarah at the agreed $25 and then he can sell them back on the open market for $30 and make an instant $5.

Alternatively, if Microsoft is trading at $20, then buying the shares from Sarah at $25 is too expensive as he can buy them on the open market for $20 and save $5. In this situation, Peter would choose not to exercise his right to buy the shares and let the options contract expire worthless. His only loss would be the amount that he paid to Sarah when he bought the contract, which is called the Option Premium - more on that a little later. Sarah would, however, keep the option premium received from Peter as her profit.

All in all, there are more than 50 strategies you can deploy in options trading by combining many different strike prices and expiration. But do you need to know all?

The good news is you do not have to!In fact, most of them allow you to make money very slowly or limited.

By : Andy Poon

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Stock Market Terminology

Stock Market terms can be intimidating for the novice, and Stock Options can be even more difficult to grasp. Understanding stock market terms is the first step in stock market eduction. It will allow you to understand all the information on this site. Consider it as a dictionary or a glossary of the most common stock market terms related to stock and options trading. It will be updated regularly and you can leave comments on which stock market terms you wish to be included.


Bearish a view someone has where they are expecting the stock market, or a stock price to fall.

Bullish a view someone has where they are expecting the stock market, or a stock price to rise.

Neutral is a view someone has where they are neither bearish or bullish. There are options trading strategies suited to this, requiring little or no movement.



Stock Options give the holder the right to buy or sell particular shares at a fixed pre-determined price within a fixed period of time. Stock options can be traded in the same way that the underlying stock can be bought and sold.

Underlying Security is the stock that an option taker has the right to buy or sell if they choose to exercise.

Some terms that relate to the mechanics of stock options:

Call Options give the holder the right to buy the underlying stock at a fixed pre-determined price within a certain, fixed period of time.

Put Options give the holder the right to sell the underlying stock at a fixed pre-determined price within a certain, fixed period of time.

Strike price This is the fixed, pre determined price at which you can buy or sell the shares. This cannot be changed throughout the life of the option contract.

Expiry This is the date at which the option contract expires. This cannot be changed throughout the life of the option, and there after the contract is worthless.

Exercise The process of fulfilling the put option contract and buying or selling the shares. This can be done any time up to and including the option expiry date.

Premium The amount you pay for the option contract. Each stock has set strike prices for trading. Depending on where the strike price is in relation to the current share price, influences the amount you pay. Premium is the sum of both the options intrinsic value and time value.

Contract Size The amount of underlying stock covered by an option contract. In the U.S this is 100 shares, and Australia it is 1,000 shares. This can vary at times. A broker is able to confirm this for you.

Writer is a trader or investor who sells an option.

Taker is a trader or investor who buys an option contract.

Some terms that relate to the pricing and values of stock options:

At the Money when an options strike price is the same as the current stock price, it is said to be at the money.

In the Money A call option is in-the-money when the underlying stock price is higher than the strike price of the call, and a put option is in-the-money when the stock price is below the strike price. The option would have intrinsic value.

Out of the Money A call option is out-of-the-money when the stock price is below the strike price, and a put option is out-of-the-money when the stock price is higher than the strike price. The option would have no intrinsic value.

Intrinsic Value is the difference between the current stock price and the strike price. This is the amount by which an option is in the money, and indicates the value of an option if it were to expire right now.

Time Value is the difference between an options current value and the intrinsic value.

Time Decay Options are made up of time value and intrinsic value. As you get closer to the expiry date, the option value diminishes. This is called time decay. When you buy an option, you are buying time.

Fair Value is used to describe the value of an option as calculated by a mathematical model. Also used to indicate intrinsic value.

Theoretical Value The price of an option as calculated by a mathematical model.

Overvalued describes a stock trading at a higher price than it logically should.

Undervalued describes a stock that is trading at a lower price than it logically should.

Some terms you will hear when dealing with a stock broker:

Full Service Broker is a broker you deal directly with to execute all transactions and orders. They come with higher fees, but highly recommended when you begin trading.

Online Broker many broking firms offer an online trading platform that allows you to control your orders with the click of a mouse. The fees are usually a fraction of the full service brokers.

Discount Broker is a brokerage firm that offers low commission rates.

Ask Price is the price at which an option seller (writer) is willing to sell. We buy option contracts and stocks on their ask price.

Bid Price is the price at which an option buyer (taker) is willing to buy.

Bid/Ask Spread is the difference in price between the bid and ask price of an option contract. Option contracts that are highly traded (liquid) tend to have a tighter Bid/Ask Spread and option contracts that are thinly traded (less liquid) have a wider Bid/Ask Spread.

Buy to Open is an order in option trading to open a position through buying that option contract. You are said to be long that option.

Sell To Close is an order close an open position through selling that option contract. This really means you are selling an option contract that you own.

Sell To Open is an order to open a position by selling (writing) an option contract to a buyer. You are said to have short sold that option.

Buy To Close is an order to close your position. It simply means you are buying back an option contract that you have previously sold short.

Closing Order is an order placed to close an open position, whether it be a sell to close or a buy to close order.

Market Order is an order to buy or sell options at the current market price.

Limit Order an order to buy or sell options at a certain, or limited price.

Day Order an order that expires at the end of the trading day if it is not filled.

Good Until Canceled is an order that remains effective until it is cancelled or filled.

Leg in option trading strategies that involve many kinds of options, each type is known as a leg.

Long to be long is to own something.

Short to be short means to sell (or write) an options contract to a buyer. This means you have the obligation to fulfill the exercise of the option should the buyer decides to do so.

Naked Option or Uncovered Option is where the investor who wrote, or sold the option does not own the underlying security.

Position used to describe the number and strategy currently open. i.e if you had bought 12 Nov $ 20 call option contracts you would be long 12 XYZ Nov $ 20 calls.

Early Exercise is the exercise of an option contract before its expiry date.

Day trading is the process of making multiple trades that are opened and closed all within the same trading day.

Short Term Options Trading to buy and onsell stock options for profit within a period of time no more than 4 weeks in total.

Some things that may affect our decisions when to enter or exit a position:

Technical Analysis is the study of price movements on a companies stock chart in order to form an opinion of future possible price movements.

Fundamental Analysis is the study of a companies financial details to form an opinion as to the future share price movements.

Trend the direction of a stock or index price movement.

Support is a term in technical analysis indicating a price level, or floor, lower than the current price of the stock, where demand is thought to exist. This indicates that the stock may stop declining when it reaches this level.

Resistance is a term used in technical analysis to recognise a price level, or ceiling, that is higher than the current stock price and where the stock has previously traded and failed to break through.

Liquidity is the ease at which a purchase or sale can be made. Highly traded stocks have better liquidity.

Reward / Risk Ratio is a measure of how risky a position would be. Divide the maximum profit potential against the maximum loss potential, and a ratio of above 1 means that the potential reward is higher than the potential loss.

Return on Investment is the percentage of profit that you may or may not make on an investment.

Open Interest is the total number of outstanding open contracts in a particular option series. Opening transactions increase the open interest, while a closing transaction reduces it.

Volatile a stock market or stock price that moves up or down unexpectedly or drastically is known as volatile.

Volatility is a measure of the amount by which an underlying stock is expected to vary or fluctuate in a given period of time.

Volume refers to the number of transactions that took place in a trading day. This indicates the number of buyers and sellers in the market.

Stop Loss is a pre-determined price at which you have decided to exit a position once it is hit.

Stop Order is a traditional stop loss where your broker will close a position when a predetermined price is hit.

And afterwards

Realise once you have closed an open position you will realise a profit or loss.

Powerful tools to help increase your profits, but take caution:

Leverage is the power to achieve greater profit potential with a smaller amount of money. Options offer high leverage. Beware leverage can be powerful, but your potential losses could also be greater.

Margin Loan is to buy a stock through borrowing funds from a brokerage house. The stock itself is used as security, and each stock has a maximum loan ratio.

Margin Call is when the lender requests additional funds as security from the borrower in the event that the stock price has fallen below a certain amount.

And a few strays:

Derivatives are financial instrument whose value is derived in part from the value and characteristics of another financial instrument. Stock Options are derivatives of the stock they correlate to.

Index is a compilation of the prices of several common entities into a single number, such as the S&P 500 and the Dow Jones.

Index Option is an option whose underlying security is an index. Generally index options are cash-based.

Market Maker is a member of the exchange whose purpose is to aid in the making of a market, by making bids and offers when there are no public buy or sell orders.

Greeks are a set of mathematical criteria used to calculate stock option prices.

Hedge to protect against potential losses.

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