When it comes to option prices, one of the factors that determine the cost of the premium is the current level of volatility. Implied Volatility is the expectation of future volatility and Historical Volatility is a measure of actual recent volatility. Many investors purchase put options as insurance for their positions. And like any insurance, the riskier the item that is being insured, the more money it will cost to insure it. For example, insuring a property in an area where hurricanes or tornadoes are common will cost more than an area where the weather is less hazardous. It will cost more to insure your home as its burning down than it would before it caught fire. Insurance on a Ferrari will cost more than insurance on a Hyundai, because it will cost more to replace a damaged Ferrari. The same goes for stocks. Some industries are more volatile than others and will cost more to insure, but also, there are times when a stock is more volatile than its historical level of volatility. At those times where volatility is higher than usual, aka Implied Volatility, option premiums cost more than usual. This doesn’t bode well for option buyers, but we have already determined that part of our investing strategy is to be a seller of options, not a buyer. So, when the option premiums are higher than normal, (higher than the recent past) we get paid more than we usually would.
If you are going to use TD Ameritrade’s Think or Swim software, which is free, they have a really good chart that you can use which shows you the historical and implied volatility next to each other. The first chart below is Express Scripts. You can see on the chart to the far right, the Green Line represents Implied Vol and has a reading of .325. It had a recent spike over the uncertainty of what President Elect, Donald Trump was going to do to the pharma/healthcare industry. The initial spike calmed down, but the Implied Volatility is still higher than Historical volatility which reads 29.7. Not a huge difference, but premiums are higher now than normal, so an options seller will collect more now than when Implied Volatility drops below the reading of historical volatility.
The next chart shows a bigger spread between Implied and Historical volatility. Bed Bath and Beyond has had an up and down year, mostly down. For someone looking to profit from that volatility, now is a good time to sell a put, or if you already own shares, selling a call will get you more premium now too.
This chart is ideal for put and call sellers. Look at how big that spread is. Implied Volatility (green Line) is at .362 and the historical volatility (pinkish purple line) is at .215. If Implied Volatility is high, we need to be sellers because premiums are expensive. If Implied Volatility is Low, premiums are cheap, so we should be buyers (but only if every other criterion matches up because buying options is very hard to way to make money). We talk more about this in our course.
Here is a tip that I go by. If implied volatility is high, we need to sell long term options to collect higher premiums. Take advantage of the unusually high premium. Once volatility comes back down to normal, we can close out the trade early and most likely keep most of the profit without having to wait the entire length of the term. I very rarely buy options, so if volatility is low, we need to sell short term options. Don’t lock up your principal long term if the money we are collecting isn’t worth our time.