Profit with Implied Volatility (Part VI)

On the road to consistent trading profits, you must understand implied volatility (IV).  In the last installment of this IV primer, I covered some theoretical takeaways to remember and today I will add a couple more.

Option trading is sometimes described as “volatility trading,” and hopefully now you have an idea why.   With stocks, the goal is to buy lower than you sell.  With options, the goal is to buy low IV and sell higher IV.  Straddles and strangles are examples of nondirectional trades that can increase or decrease in value only based on IV.  The pre-earnings trade described at http://www.optionfanatic.com/2012/04/10/profit-with-implied-volatility-part-iv/ is designed to take advantage of this.  Regardless of how or whether the stock moves, the trade aims to profit by buying IV low and selling it high.

Since IV may be interpreted as the market’s expectation for future price movement in the underlying, one could trade discrepancies between IV and the underlying’s historical price movement.  Historical volatility (HV) is the average close-to-close move of the stock over the last X trading days.  If IV is much higher (lower) than HV then you may consider the market’s estimate to be too high (low).  These options might be ripe to sell (buy).  In The Trading Guide to Conquering the Markets (2000), Robert Pisani labels IV/HV ratios at or below 0.70 as underpriced options to buy.  Overvalued options that should be sold have ratios at or above 1.40.  One could develop this strategy into a trading system.

Unless something else comes to mind, I will look to conclude this IV primer with my next post where I will summarize IV alongside other types of financial volatility.