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How Implied Volatility Figures In Options Trading

The first step to trading options based on implied volatility is to buy and sell them correctly at the best possible price. This may sound difficult but can be made relatively easy by option trading software.

A simple method is to list a series of options on your screen, and to look at two particular numbers, the actual price of the option (the ask price) and the theoretical value of the option, which is derived from the Black-Sholes formula, the benchmark equation for valuing options. Black-Sholes values are based on underlying price, option strike price, option premium, historical volatility, expiration date, interest rate, and dividend rate.

The difference between the ask price and the theoretical price is the key, with the largest difference between the two numbers giving you the “largest discount” and leading you to the least expensive option in the series. To find the most expensive option, you would rank the series in reverse and look for the smallest difference in the two prices, or the “smallest discount.”

It is always useful to keep an eye on options trading activity, because market makers often smell that something is up and start buying options for their own accounts to cover their short positions. Market makers tend to be short more often than not to protect themselves, because with access to all the trading activity data, they have better information than the public in general.

When option volume and implied volatility pick up, look at the underlying assets and at the action in other option series. If the underlying asset doesn’t make a move and the action in other options doesn’t start to pick up, what’s probably happening is that a hedge fund or other market mover is putting on a big hedge or establishing a large position to protect its portfolio.

When you see big rises in trading volume and implied volatility in an option, it’s a fairly good sign that somebody knows something that few others know. Staying away from such trades, or at least not selling in volatility, is a good idea. These can be highly risky situations that can turn on a dime and can make you lose money very quickly.

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