Implied Volatility

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[Get Daily Trade Alert Now]( About TradeWins [Inside Trading Newsletter]( [Webinars]( [Videos]( [Trading Strategy]( [Options]( [Futures]( [Forex]( [Day Trading]( [Subscription Services]( [E-Books]( [Customer Satisfaction Survey 2018]( Lee Gettess' Market Sense [Market Sense] Lee Gettess is a top trader who is excited to bring you his video newsletter. Each week, Lee will share his predictions on what he anticipates from the bond and S&P markets. [Watch Video]( Implied Volatility by [Rob Roy]( [Option Axiom] With almost every type of option trading, implied volatility is the most important consideration. This is twice as important with Straddles and Strangles, as the trader is purchasing both a call and a put, doubling exposure to changes in implied volatility. Implied volatility, in simple terms, tells the trader when options are considered “cheap” or “expensive”. Not cheap or expensive as it pertains to the trade’s cost or in relation to the trader’s account size. Rather, cheap or expensive pertains to the “normal” cost of that particular stock’s option values. Think of options as a form of insurance (which is why they were initially created) for a stock. The analogy could be made that the options are to stock, as house insurance is for a home. For this example imagine you are moving to Florida and looking to buy a house for cash. You find a great house right on the beach and buy it on the spot. You are so excited about your purchase that you immediately decide to sit on your back deck and enjoy looking out across the water. Everyone knows that in Florida it is important to get hurricane insurance to protect your investment. Sitting on your deck you look up at the sky, the weather is clear and bright, so you decide you will call the insurance company tomorrow. You know that the cost for buying hurricane insurance today will be the same price tomorrow. The majority of the time you would be right. The likelihood of your house being hit by a hurricane today or tomorrow is statistically the same. The next day you wake up to a grey sky, the wind is blowing the coconuts off the palms outside, and the clouds are swirling in circles above your house. NOW you decide is the time to buy the hurricane insurance for your new house. Upon calling you discover the cost to insure your house is now astronomical. There are of course several reasons for this. The probability of your house getting hit by a hurricane has risen significantly. The insurance company knows this, you know this, and the insurance company knows that you know this. The insurance company will raise the cost of the insurance because your house is likely to get hit by the hurricane. They do not want to lose money by taking on your risk. They also know that you are fearful of your house getting destroyed because the situation has become more volatile. So, they increase the insurance, playing on your emotions, knowing you will buy at an increased price to protect your property. Thankfully, the hurricane veers away and your house is safe. If you were to call the insurance company after the storm has passed to buy your insurance, the prices would be back to the normal levels. Options work the same way. Imagine the options were the insurance. When the cost for the same protection rises, this extra cost is factored into the option’s value as implied volatility. The option prices are raised because the likelihood of the traders needing the protection has gone up, as well as the emotional component of the trader willing to pay more the protect themselves. Unlike the house example (where the insurance buyer would need to own the house for which they are buying insurance), the trader does not have to own the underlying stock to buy the options. In simple terms, this relationship between stock and option pricing is what drives the relationship of option costs. To turn this example from houses to options, imagine there is a trader who buys stock in company XYZ. To protect the stock value the trader would need to purchase put options. Currently the puts are trading for $2. The trader believes the stock will be going up and decides not to buy the puts to protect their stock. News comes out and the trader hears that company XYZ is being investigated for accounting irregularities (not that this ever happens). The trader decides they NOW need to protect their stock investment through purchasing put options. When the trader looks at the put prices, the put options are now trading at $4. The reason the put prices have gone up is because the people willing to sell puts know that the stock is probably going to experience some volatility, and stock traders will be more likely to buy puts to protect their stocks. In fact, by raising the cost of the options, the option sellers are implying their belief of volatility rising. Days later, the news changes and the company XYZ is in the clear; their accounting was sound and correct. The fear of the unknown in regards to this stock is over. If the stock trader were to look at the put costs now, they would see the put options are trading back at $2. What this tells the trader, is that the cost of the options, or implied volatility, stems mostly from fear: Fear of losing money, fear of the unknown, or simple bad news on the stock. When any of these fears come into the marketplace the cost of options go up. When fear subsides into complacency, the cost of options goes down. All this can be seen through implied volatility. This relates directly to Straddle and Strangle traders. When creating a Straddle or Strangle, the trader purchases both a call and a put. To close the trade, the trader sells the options back. Buyers want to buy “cheap” and sell “expensive”. If the implied volatility is too high, the trader might well be buying a Straddle or Strangle that is too expensive. This creates a profitability problem. Assume the trader is looking to double their money (not part of this system necessarily, just using this for example). The more expensive the option prices are the larger a move is required from the stock for the Straddle or Strangle to profit. In this example, the comparison between the same Strangle will be made with different costs due to implied volatility. The picture below will show two Strangles. The green Strangle is trading with lower implied volatility and costs $1. The red Strangle is trading with higher implied volatility and costs $3. [Read More]( [www.tradewins.com]( [Facebook]( [Twitter]( [LinkedIn]( [Youtube]( [Better Business Bureau]( © Copyright 2018 [TradeWins.com](. All rights reserved. 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