Implied Volatility - a must know when trading options!

Implied Volatility

One of the most important secrets for pulling profits out of the markets on a regular basis is called Implied Volatility. Implied volatility is a computed value that has to do with the option itself, rather than the underlying asset.
-- The PitMaster

To take advantage of implied volatility, we must calculate Volatility Ratios. (Work with your broker to accomplish these calculations.)

	The 20 day Volatility Ratio is calculated as 1 Day Implied Volatility divided by 20 Day Statistical Volatility.
	The 90 day Volatility Ratio is calculated as 1 Day Implied Volatility divided by 90 Day Statistical Volatility.

Key Point:
When the implied volatility of an option stretches very far above or below the actual statistical volatility, statistical volatility acts like a rubberband, pulling the implied volatility back towards it.

	When implied volatility stretches far above statistical volatility, the volatility ratio is high and the options are overvalued. When the implied volatility snaps back (decreases), it will drain premium out of the options (the options will lose time value).
	In fact, if you were to purchase an option with a high volatility ratio and the implied volatility decreased, you might actually wind up losing money even if the price moved in the direction you expected! There is a name for this common situation. It is appropriately referred to as "volatility crush." You can take advantage of this situation by selling options, instead of buying options in this case. You will see how to do this in some of our Option Strategies.
	When implied volatility stretches far below statistical volatility, the volatility ratio is low and the options are undervalued. When the implied volatility subsequently increases, it will inflate option premiums, partially offsetting the effect of time decay. This is a good time to buy options.

If you would like to learn more about how to use volatility in trading, there are several good books on the subject. Our two favorites are from David L. Caplan.

	The Option Secret -- by Opportunities In Options
	The New Options Advantage