In contrast to historical volatility, which looks at actual stock prices from the past, implied volatility looks toward the future. Implied volatility (IV) is often interpreted as the market’s expectation for the future volatility of a stock and can be derived from the price of an option. Specifically, IV is the expected future volatility of the stock that is implied by the price of the stock’s options. But let’s make it even simpler by saying IV is how cheap or expensive options are. Below we will take a brief look at how IV levels can make vertical debit spreads cheap or expensive too.
General IV Levels
Option traders must also compare IV now with IV in the past. This helps traders understand whether IV is high or low in relative terms. If implied volatility is higher than typical, it may be expensive and possibly a good time to be selling premium. If it is below its normal level, it may be a good time to buy premium because options may be underpriced. This same thought process can be applied to both bull call and bear put spreads. Let’s look at some examples.
IV Helping a Bull Call
Without getting too detailed, buying lower IV than what you are selling is a good thing. Buy low and sell high. It reduces the risk of the trade, which enhances the reward. Who doesn’t like that? In the example below, the IV for the long 13 strike call is at 57.20% and the short strike at 15 is at 74.28%. This absolutely makes for a better risk/reward trade than if both IVs were equal or reversed. It is hard to predict when you will find these favorable IV levels, but when you do take advantage of them.
IV Hurting a Bear Put
Of course, the opposite is also true. If IV is higher for the long option and lower for the short option, it makes the risk/reward worse than if equal or like the above example. Take a look at the bear put spread below. The long 13 strike is at 74.36% and the short 13 strike is at 57.25%. Here an option trader would be selling low and buying high. Certainly, not desirable IV levels. This might actually keep you from taking this position because you would be putting yourself into a hole so to speak.
Final Thoughts
There are a lot of moving parts when it comes to learning about options, and having a general understanding of IV levels and how they can help or hinder your risk/reward cannot be stressed enough. The buy low and sell high principle should be remembered when analyzing volatility, but as always the most important part of the trade is that the underlying cooperates as forecast.
