Implied Volatility

A drug company’s only drug is set for an upcoming FDA decision… if it passes the stock will soar. However, if rejected, shares will plummet.

Although we don’t have a crystal ball, I think we all can agree that a catalyst of this magnitude is going to cause the stock to move more than usual. 

How about this one? 

For most companies, its earnings release date is its most volatile trading day of the year. 

Knowing that, would you expect an option to be more expensive ahead of an earnings release or after?

Of course, the uncertainty behind the catalyst will create pent up demand for both calls (speculators believing that the stock will soar) and puts (stockholders buying protection) causing the options price to spike, too. 

But if it isn’t the stock price that’s driving the options price up, what is?

It’s the implied volatility. 

You see, options traders are not dumb. They know that an upcoming catalyst is going to cause massive volatility, and because of that the risk premiums in options go up. 

For example, let’s say stocks start collapsing, a portfolio manager’s first instinct will be to buy put protection. But guess what? With everyone having the same idea, the overflow of demand increases the implied volatility in options. 

The higher the implied volatility — the more expensive an option costs. 

Example:

Let’s say Wingstop Inc. (WING) is trading at $100 per share. And you are bullish the stock, so you decide to buy the at-the-money 100-strike call that expires in 30 days. 

Here is an example of what those options would cost at different implied volatilities:

At 25% Implied Volatility: $2.86 

At 35% Implied Volatility: $4.00

At 60% Implied Volatility: $6.86

As you can see, there is a major difference in the price of the option when you increase in the implied volatility. 

Remember, implied volatility is driven by the forces of supply and demand. 

What causes implied volatility to rise?

• Uncertainty
• Fear/Greed 
• Upcoming catalysts (FDA, Earnings, Court Ruling, Product Announcement, Investor Day Conference, etc.)
• Demand from option buyers

Volatility tends to revert back to the mean. In other words, periods of high volatility are often followed by periods of low volatility.