Volatility directly affects the price of any option. Volatility is nothing but the measure of the price change of a security, reflecting the degree of risk. Higher volatility means the price can change rapidly both up and down. We will learn more about it in this article.
Understanding IV
Volatility is of two types: ‘Historical volatility’ (HV) and ‘Implied Volatility’ (IV).
Historical volatility means the actual volatility demonstrated during the prior period of time, like the past month or the past year. Implied volatility is the anticipated volatility of any underlying asset, depending on the current option price.
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High IV often emerges during earnings, macro events, sudden corrections, or fear-driven spikes. Prices whip around, trend breaks suddenly, and option premiums expand sharply.
Low IV, on the other hand, tends to show up in stable markets. Trends may be slow but consistent. Range-bound behaviour is common. It is in these phases that traders feel tempted to buy options because they look cheap, although not all cheap options behave generously.
Depending upon the level of volatility, traders use different strategies to become profitable. We will discuss some of the most used strategies during high IV and low IV conditions.
Best Strategies for High IV
Here are some best strategies for high IVs:
1. Short Straddles
A short straddle expresses a view that the underlying will not make an unusually large move after IV drops. It works well when markets overprice fear. In strategy, traders sell (write) both an at-the-money (ATM) call and put option on the same underlying asset with the same strike price and expiration date, aiming to profit from minimal price movement (volatility crush/time decay).
2. Short Strangles
Similar to straddles but with strikes set further apart, strangles reduce directional exposure while still collecting significant premium.
A short strangle involves the following simultaneous actions on the same underlying asset and with the same expiration date:
Selling one out-of-the-money (OTM) call option with a strike price above the current market price.
Selling one out-of-the-money (OTM) put option with a strike price below the current market price.
By selling both options, the trader receives a net premium (credit) upfront, which is the maximum potential profit for the trade.
3. Iron Condors
The iron condor strategy is well-suited for a high implied volatility (IV) environment, as high IV inflates options premiums, allowing you to collect a larger net credit when selling the spread. The primary goal is for volatility to decrease (IV crush) and the underlying asset to remain within a specific price range until expiration.
A standard short iron condor involves four legs, all with the same expiration date:
Sell one out-of-the-money (OTM) put option.
Buy one further OTM put option for protection (the "wing").
Sell one OTM call option.
Buy one further OTM call option for protection (the "wing").
Best Strategies for Low IV
Here are the top strategies.
1. Long Calls and Long Puts
Buying long calls and long puts is an effective strategy when implied volatility (IV) is low, as options premiums are cheaper, allowing traders to position for a significant directional move and/or an expected increase in volatility.
Traders use this condition as an opportune time to buy options (go "long") because their value will increase if the stock price moves in the anticipated direction and if volatility expands, which often happens when a stock breaks out of a quiet period.
2. Debit Spreads
Debit spreads are essentially refined versions of long options. They reduce cost and theta exposure by pairing bought and sold options.
There are two types of debit spreads here. Bull Call Spread, which is used when you expect a moderate rise in the asset's price and Bear Call Spread, when you expect a moderate drop in the asset price.
3. Long Straddles
In this strategy, buy one At-The-Money (ATM) call and one ATM put, both sharing the same strike price and expiration date. These are more expensive as the strike prices are closer to the market price. It requires a significant price move to cover the higher premium paid.
4. Long Strangle
Buy one Out-of-The-Money (OTM) call and one OTM put, both with the same expiration date but different strike prices. These are generally cheaper but require a larger price move to reach the wider breakeven points.
Conclusion
Trading volatility is respecting how markets price uncertainty. On the other hand, High IV and low IV environments create entirely different opportunity sets. Option sellers thrive when fear is inflated. Option buyers thrive when complacency creates mispricing.
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