Implied Volatility is Unimportant

Read any options trading article, listen to any pony-tailed pundit, and it will not be long before you'll hear the term "implied volatility." Pundits appear on cable news shows and opine about the VIX--an index representing the implied volatility of options contracts on S&P 500 futures--as if it was one of the most important financial gauges in the world.

Well, the joke is on them. Implied volatility is unimportant.

The only form of volatility that should matter to an intelligent option investor is something known as realized volatility. 

Realized volatility is how much a stock actually moves (measured after the fact); this is in contrast to implied volatility, which is the market's best guess (made before the fact) of how much a stock will move.

Let's take a look at the difference between these two flavors of volatility with a simple, eye-opening thought experiment.

Let's say that you know with certainty that a certain stock, ABC, trading for $50 right now is going to be worth $75 at the end of a 1-year time period. You don't know what's going to happen to the stock in the interim, but somehow have perfect, precise knowledge of what the market price will be in 365 days.

How much would you be willing to pay for an At-the-Money (ATM) call option under these circumstances? (Readers of The Intelligent Option Investor know that I would never recommend buying an ATM option, but in this case, I'm using it to make the arithmetic easier)

Because you have perfect knowledge of what the future price will be, this investment will be risk-free for you, but let's say that you're a little greedy and would like to earn at least a 10% return on my investment.

To earn a 10% return on an ATM call option under these conditions, you should be willing to pay $22.73. [1]

What is the implied volatility on a $22.73 European call option struck at $50 with a present stock price of $50, a risk-free rate of 3% and 365 days to maturity? Plugging these variables into any old option calculator and I get...

118%!

So in this instance, any implied volatility less than 118% would be "cheap" for you. 

To put this number in context, most experienced option traders would probably consider an implied volatility of half of that figure as "very high." 

If we find out how expensive an ATM option would be if it had a very high implied volatility of 58%, we might be surprised to find that we would only pay $12 for it. If we only paid $12, we could make $13--over 100% return--on our investment.

The moral of the story is that it doesn't matter how much the market thinks a stock will move, but, for a long-term investor, by how much it actually ends up moving in the end.

Implied volatility is nothing. Realized volatility is the key to investing success.

NOTES:

[1] 

For a desired 10% return, we know that the call option will be worth $25 at expiration, so our investment will be:

Investment * 1.10 = $25.00

$25.00 / 1.10 = x = $22.73