Implied volatility is not Historical volatility
Being an options trader, you need to understand both concepts regarding volatility: historical volatility and implied volatility.
Historical Volatility is defined as “the annualized standard deviation of past stock price movements.”. In essence, this shows how much the stock price fluctuated on a day-to-day basis over a one-year period. So, the thing to remember is that historical volatility reflects the price movements of a particular stock.
On the contrary, Implied volatility isn’t based on stock price movement. Instead, it’s what the market participants are “implying” about the stock volatility will be in the future. This is based on the premium (or price of an option) of its options. Based on the news in the market, option prices will begin to change like stock also moves. For example, one event that drives up the implied volatility and consequently options premium (or prices) is an earnings announcement. This is independent of stock price movement.
Both historical and implied volatility is expressed on an annualized basis. But implied volatility is the value to focus on to any option trader because this is the basis of the premium (or price) to pay for a particular option (Call or Put).
Compare both charts for SPY and TSLA is a given period. In the below chart of each (light blue line), you can see the implied volatility chart.
Implied Volatility trading implications
Before entering into details about Implied Volatility (or IV) and its huge relevance on options trading, I would like to point out that, I base all my strategies (entry and exit points) are much more dependent on Delta values than on stock or ETFs price movements (or price points). This is because Delta also varies with IV (and time, and quote position, etc). My strategies are based on probabilities and when are applied will adapt to each moment’s market conditions! So, when I open a trade with at a 30 Delta Call in a low IV environment, probably this means a 3% move from the actual price. But, maintaining the same strategy in a high volatility environment, could mean an 8% move or more! As you can conclude, when dealing with options it is better to think about probabilities than of percentage price move! What I mean is, if you sell a Put 10% OTM (Out-the-money) because you expect to collect premium due to stock move higher or stays at the current level it does not mean anything to me if I cannot understand if that stock is low or high volatile. If you tell me that you are selling Put at -10 Delta, this has a different meaning to me! It does not matter, in this case, if a stock is high or low IV… you sell a Put to collect premium with an average chance of 90% of the options expire worthless at expiration.
What is Implied Volatility?
When you trade stocks, only price variation enters into the equation because if you are expecting it to move up, you simply buy the stock (or short the stock if you expect it to move down). When dealing with options, many factors will impact its price. The Implied Volatility (or “IV”) is the main driver that impacts the value of the option. When you take a long position in a stock you expect it will increase in price. When you have a net long position in options you expect its Implied Volatility is low and expect its IV will increase in the future (well, there are other factors involved, but in a simple way, this is what to expect). So, like in stocks, “Sell High and Buy Low” also applies but for IV in Options! We need to select the options strategies to apply and we should take the IV level into account! In fact, I check more often the IV level of a Stock than its price chart (I am an options trader; not a stock trader!).