Implied volatility is one of the least understood and most powerful parts of any option trader’s toolkit. In fact, implied volatility is very simple to understand but you wouldn’t necessarily think that when you first read the definition, which states: implied volatility of an option contract is the volatility of the price of the underlying security that is implied by the market price of the option based on an option pricing model.
So what on earth does that mean? Simply put, you can think of the implied volatility as something which increases the price of options when stocks are gyrating wildly or have the potential to do so. When fear levels increase in the market or there is an expectation that a stock will move substantially in either direction, implied volatility levels will increase causing option prices to look very expensive.
The common barometer for volatility in the markets is the VIX, and it’s also known as the Fear Index. The reason being that when the Volatility Index or VIX, rises it tends to correlate with downtrends in the markets or fear of lower prices. Conversely, when the Volatility Index drops to lower levels, it tends to be reflective of complacency in the market.
The Volatility Index will typically oscillate between 10 and 50, with the low end of the range reflecting market complacency and the high reflecting market fear. Of course, the volatility index can drop below 10 and rise above 50 and in these cases typically extremes in the market are observed, which often correlate well with major market turning points. It’s not always the case though which is why other indicators are important to pay attention to also.
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