REVEALED: How to Profit Using Implied Volatility

REVEALED: How to Profit Using Implied Volatility

Posted On May 3, 2022 1:01 pm

The term volatility gets thrown around a lot, often used interchangeably for big price moves, especially with perceived risk. 

 But for options traders, volatility, or more specifically implied volatility has a very defined meaning and is crucial to understanding the probability of profitable trading.   

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On Monday, the CBOE S&P 500 Volatility Index (VIX) crossed above the 35% level as Options360 established a put spread on the notion that implied volatility will drop back below 28% within the next two weeks.  

Having made that trade in the VIX, I thought it would be helpful to cover what implied volatility means.  

 I often use the analogy that you don’t need to be able to build an engine to drive a car, just know the gas from the brake.  However, a rudimentary understanding of how the parts work and are connected helps you avoid accidents and enhance performance.  

 Likewise, you don’t need to get all geeked out on the Black-Scholes model to trade options.  However, a basic understanding of options pricing and behavior under a variety of conditions will go a long way to successful trading.  


Implied volatility is a “plug number” (a placeholder for an accurate calculation estimate) used to make the result from the  commonly-used apparatus for valuing options (Black-Scholes model), which considers 5 factors when calculating an option’s theoretical fair value:  

  1. The price of the underlying security 
  1. The strike price. 
  1. The time, or expiration date of the option 
  1. Interest rates * this is becoming increasingly important in the rising rate environment and with upcoming FOMC meetings.  
  1. Implied volatility.  

The first four inputs are known variables. To get number five, we plug those four inputs into the Black-Scholes model; giving us “theoretical” implied volatility This helps us decide whether an option is cheap or expensive. 

 But, given that options trade regularly, there is an “actual” implied volatility assigned to each option based on its price, which constantly updates in real-time.  

 There are two features of implied volatility that tend to be poorly understood.  First, it’s a derived number and second, it’s expressed in annualized terms. 

So, what does the actual or real-time implied volatility tell us?  This is where we get into the weeds of math and probabilities. 

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  • IV is a proxy for standard deviation. 
  • Price should remain within 1 standard deviation 68% of the time during the course of a year.  

implied volatility chart

To get this into a manageable form, particularly for short-term options, we want to translate this into a daily time frame.

This brings us to the ‘rule of 16’ where you take the square root of the 256, the number of trading days in a year or 16, to calculate the expected daily move.  

For the math geeks out there, this is the formula:

the rule of 16 formula


  • A 25% implied volatility on a $100 stock should remain within $75-$125 for 68% of the time.   
  • Applying the rule of 16 (25/16) translates into an expected 1.56% daily price move.  

When the VIX currently hit 35% yesterday it was suggesting the SPY would move 1.18% on a daily basis. 

  Understanding implied volatility will help your buying or selling options decision-making and make you a more profitable trader.

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About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.