Implied volatility on the other hand refers to a future expectation of price fluctuation. The higher the implied volatility the more one could expect the stock or underlying instrument to move in either direction. Conversely, the lower implied volatility references a more stagnant underlying instrument. This implied volatility is an extremely important component of options pricing and its effect on an options price is what makes an option either "cheap" or "expensive". Rising implied volatility makes options more expensive and conversely decreasing levels of implied volatility makes options less expensive.
Of all the inputs that go into pricing models such as the Black-Scholes options pricing model, implied volatility is the only variable component. The other components of the pricing model are exercise (strike) price, the riskless rate of return, time until expiration, and the price of the underlying. Implied volatility (variable) is determined by the market maker and is based on the public's expectations of upcoming events that may change the ultimate value of the options contract. Market makers who are charged with making a market for these instruments increase and decrease implied volatility to increase or decrease the price of the option. The other components mentioned above are all factual and are not based on subjective interpretation.
Because of what I just mentioned above, sharp traders realize that money can be made in strategies that exploit the expected moves (or lack of movement) in implied volatility. There are many strategies that can accomplish this but the general rule of thumb is that if your expectation is for decrease in implied volatility, then being a seller of an options contract would behoove you . Conversely the opposite would apply; being "Long Vega" or buying volatility would benefit the trader who believes implied volatility is set to rise.
Of all the inputs that go into pricing models such as the Black-Scholes options pricing model, implied volatility is the only variable component. The other components of the pricing model are exercise (strike) price, the riskless rate of return, time until expiration, and the price of the underlying. Implied volatility (variable) is determined by the market maker and is based on the public's expectations of upcoming events that may change the ultimate value of the options contract. Market makers who are charged with making a market for these instruments increase and decrease implied volatility to increase or decrease the price of the option. The other components mentioned above are all factual and are not based on subjective interpretation.
Because of what I just mentioned above, sharp traders realize that money can be made in strategies that exploit the expected moves (or lack of movement) in implied volatility. There are many strategies that can accomplish this but the general rule of thumb is that if your expectation is for decrease in implied volatility, then being a seller of an options contract would behoove you . Conversely the opposite would apply; being "Long Vega" or buying volatility would benefit the trader who believes implied volatility is set to rise.
No statement in this web site is to be construed as a recommendation by Trading Options For Income to purchase or sell a security, or to provide investment advice. Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options . Copies of this document may be obtained from your broker, from any exchange on which options are traded or by contacting The Options Clearing Corporation, One North Wacker Dr., Suite 500 Chicago, IL 60606 (1-800-678-4667).
Madeira Investments LLC
D/B/A Trading Options For Income
8770 Sunset Drive # 201
Miami, Florida 33173-3512
Tel: 305-432-5066
Fax: 305-279-0532
Copyright © 2008 Trading Options For Income. All rights reserved
Madeira Investments LLC
D/B/A Trading Options For Income
8770 Sunset Drive # 201
Miami, Florida 33173-3512
Tel: 305-432-5066
Fax: 305-279-0532
Copyright © 2008 Trading Options For Income. All rights reserved
