Implied Volatility is a term that many traders use, but few understand completely. Most traders know that almost any implied volatility number you see is for an annual move, but couldn’t explain how or why it’s quoted that way. We’ll explain briefly here, and tell you why it matters during earnings season.
An implied volatility number for a given month of options on a security tells you the annualized expected move for that security during the time until expiration. So, the SPY August options with 32 days to expiration have 17-or-so percent implied volatility, and this tells us that SPY should move about 5% up or down - around $7 in either direction by expiration.
If we look at September options with 67 days to expiration and a 19% implied volatility, there is an expected move of roughly 8%, or $11 in either direction.
That’s a much larger range in September than in August, but even though it’s about twice as many days to expiration, the expected move is only about one-and-a-half times as large. This is due to the nature of implied volatility - expected movement over time.
As you can see in the included image, a range of prices expands as time passes, but at a slowing rate. So the difference in expected move between options 10 and 20 days until expiration will be quite large, but the difference between options with 300 and 310 days to expiration would be quite small.
Keep this in mind when trading at earnings. Even though you see a similar implied volatility number for weekly options and those far out one-year options, recognize that the expected move in the stock (the same for both options, as they are on the same underlying) is substantially higher when compared to the price of the options (the short-term weeklies will be MUCH cheaper than annual options, obviously).
Bottom Line: Pay attention to implied volatility - the expected movement before expiration has everything to do with price, and understanding this relationship can help you identify trading opportunities. If you want to subscribe to our Earnings Trade Alerts, click here!