Pay Attention To Volatility

By Len Yates
What trader has not experienced seeing the market move in the anticipated direction, but his options gaining only very little? Betcha those options were overvalued when they were bought!
Or, covered writers: Have you ever written options and felt that you were getting unusually low premiums? Maybe you were selling when options were cheap!
Option traders measure how expensive or cheap options are using a parameter called implied volatility, or IV for short. The term implied volatility comes from the fact that options imply the volatility of their underlying, just by their price. A computer model starts with the actual market price of an option, and measures IV by working the option fair value model backward, solving for volatility (normally an input) as if it were the unknown. (Actually, the fair value model cannot be worked backward, but has to be worked forward repeatedly through a series of intelligent guesses until the volatility is found which makes fair value equal to the actual market price of the option.)

High IV is synonymous with expensive options; low IV is synonymous with cheap options. It is useful to plot an asset’s IV over a period of years, to see the extent of its highs and lows, and t