The technical definition of implied volatility is “the market’s estimate of future volatility derived from the option’s price.” In simpler words, it means that option prices are getting more expensive as implied volatility rises and option prices are becoming cheaper as implied volatility drops.
Implied volatility is calculated based on a weighted average of call and put prices of various strikes and different expirations. As the market anticipates greater future volatility of the stock price, due to some foreseen news event, option prices will start to rise. The market interprets the future news as a catalyst to cause the stock to move up or down more than normal. The demand causes option prices, both calls and puts, to become more expensive.
As an example, we are coming to the end of earnings season. We can see plenty of examples of a stock jumping a large amount on a positive earnings report. Today Visa (symbol V) rose 10.24%, an increase of $21.99 to $236.65, on a positive earnings report last night after the market closed. A couple of weeks ago Netflix (symbol NFLX) dropped $86.89 to close at $361.70, a 19.37% drop, on a bad earnings report.
When the market sees these big moves on earnings, it expects the potential is there to experience a similar big move in the future when earnings are announced again. In the weeks leading up to the next earnings announcements, the option prices for these stocks and other big movers will start to rise. Or, we can say implied volatility will rise.
As an educated investor, we should be aware of the implied volatility for the options of a stock. Ideally, we would buy options with low implied volatility and sell options with high implied volatility. This means, for the most part, that now is a good time to buy options. With earnings season mostly behind us, implied volatility has come down; meaning option prices are pretty cheap right now. However, there are still some companies that have yet to report that will still have expensive options.
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