What is Volatility?
Volatility measures how much a stock's price fluctuates. In options trading, understanding volatility is absolutely critical because
option prices are heavily influenced by expected future volatility (implied volatility or IV).
High volatility = expensive options. Low volatility = cheap options. Smart traders buy cheap options and sell expensive ones.
Implied Volatility (IV) vs Historical Volatility (HV)
📈 Historical Volatility (HV)
- What it is: Actual past price movement (realized volatility)
- Calculation: Standard deviation of price changes over time
- Backward-looking: Tells you what happened
- Objective: Based on real price data
- Example: "AAPL moved 2% per day on average over the last 30 days"
⚡ Implied Volatility (IV)
- What it is: Market's expectation of future volatility
- Calculation: Derived from option prices (using Black-Scholes)
- Forward-looking: Predicts what might happen
- Subjective: Based on supply/demand for options
- Example: "Market expects AAPL to move 3% per day before earnings"
💡 Key Insight:
When IV > HV, options are "expensive" (market expects bigger moves than historically seen).
When IV < HV, options are "cheap" (market expects smaller moves). This is the foundation of volatility trading.
IV Rank & IV Percentile Explained
Knowing an IV number (like 35%) alone doesn't tell you much. Is 35% high or low? That's where IV Rank comes in.
📊 IV Rank Formula
IV Rank = [(Current IV - 52-Week Low IV) / (52-Week High IV - 52-Week Low IV)] × 100
0-25%
LOW IV
Buy options, avoid selling premium
25-50%
MEDIUM IV
Neutral, case-by-case
50-75%
HIGH IV
Sell premium, credit spreads
75-100%
EXTREME IV
Prime time for selling options
🎯 Trading Rules:
- IV Rank < 25%: Buy options (long calls, long puts, straddles)
- IV Rank 25-50%: Neutral, use spreads to define risk
- IV Rank > 50%: Sell options (iron condors, credit spreads, covered calls)
- IV Rank > 75%: Aggressively sell premium, extremely high probability setups
💥 Earnings IV Crush - The Silent Killer
IV crush happens when implied volatility drops dramatically after a major event (usually earnings). This can destroy
the value of long options even if you predicted the direction correctly!
How Earnings IV Crush Works
| Timing |
IV Level |
Option Premium |
Why |
| 1 Week Before Earnings |
50% |
$5.00 |
Building uncertainty |
| 1 Day Before Earnings |
85% |
$8.50 |
Peak uncertainty, max premium |
| Morning After Earnings |
35% |
$3.50 |
Uncertainty removed, IV collapses |
⚠️ Warning Example:
You buy an ATM call for $8.50 before earnings. Stock moves up 5% (you were right!), but IV drops from 85% to 35%.
Your option is now worth $6.00 despite being right about direction. You lost $2.50 due to IV crush.
How to Trade Earnings
- Avoid buying options right before earnings unless you expect a massive move (>10%)
- Sell premium instead: Iron condors, credit spreads benefit from IV crush
- Use stock or vertical spreads: Spreads are less affected by IV changes
- Buy options weeks before earnings: Ride the IV expansion, sell before the event
- Buy ATM straddles 30+ days out: Less susceptible to single-day crush
🎯 Understanding Vega - Your IV Sensitivity
Vega measures how much an option's price changes when IV changes by 1%. High vega = highly sensitive to IV changes.
Vega by Option Type
| Option Type |
Vega |
IV Impact |
Best When |
| ATM Options (30+ DTE) |
High (0.15-0.30) |
Very sensitive |
Expecting IV expansion |
| ITM Options |
Medium (0.08-0.15) |
Moderately sensitive |
Balanced approach |
| OTM Options |
Medium (0.10-0.20) |
Moderately sensitive |
Lottery plays |
| Near Expiration (<7 DTE) |
Low (0.02-0.08) |
Less sensitive |
IV doesn't matter much |
| Vertical Spreads |
Low (vega neutral) |
Minimal impact |
Ignore IV, focus direction |
💡 Vega Strategy:
If vega = 0.20 and IV increases by 5%, your option gains $1.00 per share ($100 per contract).
Conversely, if IV drops 5%, you lose $100. This is why straddles work best when IV is low and rising!
📉 VIX - The Market's Fear Gauge
The VIX (Volatility Index) measures expected S&P 500 volatility over the next 30 days. It's often called the "fear index."
VIX < 15
Complacent
Buy options, expect volatility spike
VIX 15-20
Normal
Healthy market, neutral approach
VIX 20-30
Elevated
Caution, potential volatility
VIX 30-45
High Fear
Sell premium, market panic
VIX > 45
Extreme Panic
Crisis mode, sell vol aggressively
🎯 VIX Trading Rules:
- VIX < 15: Buy straddles/strangles, volatility is "too quiet"
- VIX 15-20: Normal trading, use your normal strategies
- VIX > 30: Sell iron condors, covered calls, cash-secured puts
- VIX > 40: Extreme premium selling opportunity, but manage risk carefully