Over the years we have been consistently asked, 'what is the number one common denominator that causes option traders to fail?' In our reply, if relinquished to a single reason, it would have to be a trader's deficiency with implied volatility (IV). By definition, IV is a theoretical value designed to represent the volatility of the security underlying an option as determined by the price of the option. The factors that affect implied volatility are the exercise price, the riskless rate of return, maturity date and the price of the option.
The important thing to understand about IV is how to use the results, and what affect it can have on the pricing of options. The mathematical equation that is used is less important since most pricing models will do the legwork for you. Remember that if you use the Black Scholes model, this model assumes you are going to hold the option until expiration. Conversely, if your intention is to hold for a different time period, then choose an American style pricing model such as the Yates Model; this will allow you to enter in your own criteria for your holding period and IV will be calculated accordingly.
Now let's get down to the importance of IV. Increases in IV can cause option pricing to go up; meanwhile, decreases in IV will cause pricing to drop. A 40% drop in IV could be devastating to investors' currently long options. Nothing could be worse than to make a great trade where the underlying stock went in your favor, but your option ends up losing money. The probable cause of this is likely to be a severe drop in IV. Let's take a look at First Solar below. On February 12th IV rose to historical levels of 138.7%, while average levels of IV for FSLR is 67%. What does all this mean to options buyers?
Historically high levels of IV tells us that the option market is expecting a move in the stock. It is also telling us that the options are extremely expensive, so buyers beware. If IV were to suddenly drop to its historical range then you would realize a significant drop in value in your option. Let's go back in time and take a look at the call side of the option montage for FSLR. Tuesday February 12th FSLR is trading at 181.49; the montage is showing us the strike price, bid, ask, and the mid level IV for each individual strike price. Now let's jump forward to March, 3rd FSLR, IV dropped from 138% to 69%, (referenced in the above chart) the price increased to 205.97, and there was a $24.48 rise in the stock price. The option market was correct in its prediction for a significant move in the stock. Now let's compare the second montage with its new IV. Across the board all options are significantly less. Time value has eroded a portion of your option but more importantly IV is responsible for 50% of the loss. The call writers are the big winners here. What you should be doing during times of high IV is looking for strategies that will benefit from the excess premium applied to the options. Credit spreads are generally the type of trades that would be beneficial. Once IV returns to normal levels the excess premium once applied to the option is now in your pocket. The scenario used above worked out better for option buyers than in most situations. It is unrealistic to expect a stock to move 20 to 30 points, so the options with a higher Delta appeared less affected because of the staggering move, unless you were long puts, you were then crushed in the position.
Another way to interpret IV would be to think of it as a supply and demand line. As more buyers enter the market, it only stands to reason that prices will rise. In the illustration above take notice of the short-term downward trend just prior to reversing up. It is common to see IV start to rise as a stock falls; there are general more put buyers, looking to protect, as well as speculators willing to jump on the band wagon. Now you factor in expected earnings release and you get the perfect storm.
In the chart above you will see normal behavior patterns of IV. Take notice of the high peaks in IV, you will see a common occurrence of market bottoms when IV starts hitting historical highs. Rising IV in down trending markets could be viewed as a fear factor. This will be followed by volume capitulation in the underlying, extreme levels in IV, and now we know the bottom is near. This is a great time to go long the stock and for the option traders you would place an order for a bull put spread or once again another credit spread that would take advantage of the excess premium with the stock's anticipated bullish move. Remember that option premiums are at extreme levels so you want to take advantage of that. Use the same logic you would use if you were going to buy a car. You wouldn't give the dealership a 40% premium for his car, so let the same hold true when you buy options.
Hallaman Market Research
Historically high levels of IV tells us that the option market is expecting a move in the stock. It is also telling us that the options are extremely expensive, so buyers beware. If IV were to suddenly drop to its historical range then you would realize a significant drop in value in your option. Let's go back in time and take a look at the call side of the option montage for FSLR. Tuesday February 12th FSLR is trading at 181.49; the montage is showing us the strike price, bid, ask, and the mid level IV for each individual strike price. Now let's jump forward to March, 3rd FSLR, IV dropped from 138% to 69%, (referenced in the above chart) the price increased to 205.97, and there was a $24.48 rise in the stock price. The option market was correct in its prediction for a significant move in the stock. Now let's compare the second montage with its new IV. Across the board all options are significantly less. Time value has eroded a portion of your option but more importantly IV is responsible for 50% of the loss. The call writers are the big winners here. 
What you should be doing during times of high IV is looking for strategies that will benefit from the excess premium applied to the options. Credit spreads are generally the type of trades that would be beneficial. Once IV returns to normal levels the excess premium once applied to the option is now in your pocket. The scenario used above worked out better for option buyers than in most situations. It is unrealistic to expect a stock to move 20 to 30 points, so the options with a higher Delta appeared less affected because of the staggering move, unless you were long puts, you were then crushed in the position. 