How Implied Volatility Affects Options
You may have heard of "IV crush" before, or maybe experienced it first-hand when you got the direction of a stock correct but your options still lost value after earnings. Implied volatility, or IV, is part of an option's price and represents the estimated move of the underlying stock.
Implied volatility is calculated from the difference in the price an option should be and its actual price. There are many factors that can cause this, such as supply and demand, upcoming uncertainty, and the time until expiration.
As there is more demand for an option, the price of it will go up even if the underlying stock isn't going up. Likewise, if there is more selling pressure (less demand), the price of the option will go down. Even though options are related to the underlying price, they still experience the same supply and demand effects that stocks do. So when options are more in demand, their price rises, and so does IV.
IV is also lower for expirations that are further away, as there is less demand for them and there is more time for the underlying to move, meaning that the uncertainty around upcoming events will affect them less.
For example, one month prior to earnings, options on stock ABC are priced about where they should be. There isn't any expected news that could make options any more desired than they currently are. However, as earnings approach, traders know that a big move in the stock could be coming. This causes higher demand and higher prices, and you now need to pay more to buy an option and potentially cash in on the big move.
After earnings, IV will come crashing down because there is no longer an event with an unknown outcome, and because demand is lowering as traders sell their options. There is a potential for this change in IV to lower the price of the option to a point where you could still lose money even if you got the direction correct.
On OptionStrat, you can see how changes in IV will affect your trade by moving the implied volatility slider.