A "good" Implied Volatility (IV) for options is subjective and depends on your trading strategy and risk tolerance, but generally, IVs between 20% and 25% are considered comfortable for a majority of traders.
Understanding Implied Volatility (IV)
Implied Volatility (IV) represents the market's expectation of how much an asset's price will fluctuate over a specific period. It's a crucial factor in options pricing. Higher IV generally leads to higher option premiums, while lower IV results in lower premiums.
Factors Influencing IV
Several factors can influence IV, including:
- Market Sentiment: If traders are pessimistic and buying put options to hedge against potential losses, the IV of put options increases, signalling a bearish outlook. Conversely, if traders aren't actively hedging, IV tends to decrease.
- Supply and Demand: High demand for options drives up their prices and thus, their IV.
- Event Risk: Upcoming events like earnings announcements or economic data releases can increase IV due to the uncertainty they introduce.
Determining a "Good" IV
There's no universally "good" IV, as it depends on several factors:
- Trading Strategy:
- Option Buyers: Generally, option buyers prefer lower IV, as it makes options cheaper to purchase. They aim to profit from a significant price move that exceeds the implied volatility.
- Option Sellers: Option sellers usually prefer higher IV, as it allows them to collect larger premiums when selling options. They profit if the price movement stays within the implied range or declines.
- Risk Tolerance: Traders with higher risk tolerance might be comfortable trading options with higher IV, while those with lower risk tolerance might prefer options with lower IV.
- Underlying Asset: The "normal" IV range varies across different assets. More volatile assets typically have higher IVs.
- Time to Expiration: IV tends to be higher for options with longer expiration dates due to the increased uncertainty over a longer period.
Evaluating IV
Here's how to evaluate if an IV is "good" for your specific strategy:
- Compare to Historical IV: Look at the historical IV of the underlying asset to see if the current IV is high or low relative to its past levels. This is often done using IV Rank or IV Percentile.
- Consider the Option's Premium: Assess whether the option premium is justified given your expectations for price movement.
- Factor in Time Decay: Options lose value as they approach expiration (time decay or "theta"). This is especially important to consider when IV is high, as the premium you pay might erode quickly.
Practical Insights
- Implied Volatility Skew: It's common for put options to have higher IV than call options, particularly for options with strike prices far from the current asset price. This reflects the market's tendency to hedge against downside risk.
- Implied Volatility Smile: IV tends to be higher for out-of-the-money (OTM) calls and puts, forming a "smile" shape when plotted against strike prices. This reflects increased demand for options that protect against large price swings.
