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.