Traders who are new to option trading sometimes hear the term 'implied volatility' thrown around by experienced option traders. Traders who have been training for while realize the importance of implied volatility and how it can affect their profitability. In this article, I would like to give an explanation for what implied volatility is, how is derived and how traders can use it to make money.

Options prices consist of two different components. One of these components is called intrinsic value and the other is called time value. Intrinsic value is the actual quantifiable value of the option relative to the price of the underlying stock. So, if a stock is at $51.00 and the price of the 50 strike call is $3.00, the intrinsic value of the option is $1.00. The rest of the option's price is called time value. In this case it would be $2.00.

Time value is an important concept to understand when talking about implied volatility. While the actual value of implied volatility is derived from options pricing models, options pricing models have relatively little bearing on the intrinsic value of the option. The models exist to help us understand how market changes affect the time value of the option. One of the variables in options pricing models is implied volatility.

So, in the example above, if we were to derive our greeks and implied volatility from the options price, the main portion of the options price that would be used by our model would be the $2.00 of time value in the option. This is an important concept for beginning options traders to understand because of the impact that time decay and market movement have on the time value of an option.

Market movement and time decay

Most options traders understand that options prices are affected by time decay. However, they may not be aware that as options move away from their strike price time value is also affected. This is the reason that a deep in the money option has so much intrinsic value and a far out of the money option is so cheep. They both have very little time value. As a result they also have lower implied volatility values when compared with strike prices that are closer to the money.

This can be a significant observation for novice option sellers. Since the reason for selling an option is to collect time premium, most of these beginning traders seem to think that they can only collect their time premium sold as time elapses. This is simply not the case. The seller can also collect time premium as the underlying stock moves up or down. Traders that see the strike price of the option moving deeper into the money can offset the intrinsic value of the option by selling more time premium.

Let's consider an example of a trader who has a January 50 covered call on XYZ stock. Let's suppose that the position was initiated when the price of the stock was $50. Let's also suppose that the trader collected $2.00 for the option sold. Shortly after the position was initiated the company released earnings and the price rose to $55. Now the January 50 call that was sold is trading for $5.90. So, the time value of the option sold has depreciated by $1.10 based on market movement. The trader looks at the March 55 calls and notices that they are trading for $5.95. If he rolls the option that he sold to March, he will be able to sell more time value and any intrinsic increase in the option sold will be absorbed in the long stock position of the spread. Hence, he is selling an option with higher implied volatility than the one that he is covering to complete the roll to March.

If this seems a little confusing, don't worry. Option trading can take a little time to understand. However, with the proper understanding, a trader may be able to create positions that benefit from time decay and adjust his position when the market moves against him. For many traders, the starting point for understanding how to properly trade options begins with a firm foundation and understanding of implied volatility.