Impact of Implied Volatility
Have you ever wondered why the price of a stock moved up, but the price of your long call option moved lower at the same time? When this occurs, it may sometimes be attributed to a corresponding drop in the option's implied volatility. This leads us to, "why would that happen?" Before addressing the second question, let's review of exactly what implied volatility is and why it may go up or down.
The implied volatility of an option is a risk measure that indicates the range of movement an option is anticipating out of the underlying stock over the life of the option. This number is expressed on an annual basis. For instance, if XYZ options that expire in 60 days are indicating an implied volatility of 30%, then they are forecasting a move on an annual basis of 30% over the next 60 days. There are certain times when the implied volatility of an option is higher than what is considered normal. This is usually before a potential stock-moving event, such as an earnings release.
There is usually more risk in a stock position, long or short, just before the company's quarterly earnings report or any other significant company event. Both put and call options will often have a higher implied volatility just before earnings than the options do during periods of time that do not include known news events. Once the earnings announcement has been made and the news has been disseminated to the investing public, there is less risk in holding a long or short position. With lower risk comes lower implied volatility, and lower implied volatility results in lower option premiums.
With stock XYZ trading at 65, let's say a call option with a 65 strike price that has 60 days until expiration and an implied volatility of 40% is trading at $4.25. If the implied volatility were to decrease by 10%, but there are still 60 days to expiration and the stock is still trading at 65, the option might now be trading for $3.20. In this example, the drop in implied volatility has taken $1.05 out of the value of the option.
Let's say options on XYZ normally trade with an implied volatility level of 25%. Due to higher implied volatility of 40% in the market due to an impending earnings release, XYZ options are trading for a higher price. Shortly before an earnings release, XYZ is trading at $35.25, and the trader believes the stock is going to trade lower on the release of earnings. He takes a look at a put option with a 35 strike (just below the stock price) with 10 days left to expiration that is trading at .80 and decides to buy this XYZ 35 Put for .80, or $80.
That evening, XYZ reports earnings, and the following day the stock opens down .75 to 34.50. His prediction on XYZ is correct; however, the implied volatility on the 35 Put has gone from 40% back to a historical normal level of 25%. Due to this drop in implied volatility, the XYZ 35 Put is now trading at .80, which is unchanged from the previous day.
To illustrate exactly how important the impact of implied volatility is, let's change the trade around just a little. Take the same situation, but change the implied volatility to 25% when the trade was initiated, instead of the inflated 40%. This would have had the XYZ 35 Put trading at .45, instead of .80, before the .75 drop in the stock. With no impact from a change in implied volatility, the trade would have been a winner of .35, or $35 a contact.
Monitoring Implied Volatility
Implied volatility is a difficult concept for all levels of traders, and the short nature of this article does not do it full justice. It's important to understand the potential impact a change in implied volatility has around potential stock-moving events such as earnings, and it's equally important to keep an eye on the implied volatility of a stock before taking an option position on it.