What is implied volatility in options

Understanding Stock Option Premiums

Stock option premiums tend to increase on their own before the announcement of certain events, such as general elections or quarterly earnings. Even though stock prices may change, the premiums themselves tend to rise. This phenomenon can be attributed to implied volatility.

Implied Volatility and Option Contracts

Implied volatility is a measure of the expected future price fluctuations of a stock. When you see a contract with an implied volatility of 20, it means that the underlying stock is expected to move up or down by 20%. The higher the implied volatility of an option contract, the higher its premium.

Market Reversals and Premium Increase

Implied volatility tends to revert to its average value over time. So, if the implied volatility of a stock is extremely high or low, it will eventually move back towards its average value. When your option’s implied volatility is excessively high or low, the premium will increase as it moves back towards the average value.

Using Self-Side Strategies

Traders should consider using self-side strategies when the implied volatility is significantly high or low. These strategies include short straddles, covered calls, and credit spreads. On the other hand, when the implied volatility is very low, traders should consider using buy-side strategies such as buying options or long straddles.

Market Volatility Analysis

Market volatility analysis is crucial for understanding the behavior of option premiums. By analyzing market volatility, traders can make informed decisions about their option trading strategies. It helps them identify opportunities and risks associated with different options.

Frequently Asked Questions (FAQs)

Q: Why do stock option premiums increase before certain events?

A: Stock option premiums increase before certain events due to implied volatility. Implied volatility measures the expected future price fluctuations of a stock, and higher implied volatility leads to higher option premiums.

Q: What are self-side strategies?

A: Self-side strategies are option trading strategies that traders use when the implied volatility is significantly high or low. These strategies include short straddles, covered calls, and credit spreads.

Q: How does market volatility analysis help in option trading?

A: Market volatility analysis helps traders understand the behavior of option premiums. By analyzing market volatility, traders can make informed decisions about their option trading strategies, identify opportunities, and manage risks effectively.

Q: What is the significance of implied volatility reverting to its average value?

A: Implied volatility reverting to its average value is significant because it affects option premiums. When implied volatility is excessively high or low, it tends to move back towards its average value, leading to changes in option premiums. Traders can take advantage of this phenomenon by using appropriate trading strategies.