Implied volatility is the most important input in the options valuation model. This is because it is the only input that is a user-defined variable (unlike interest rates and dividend rates for example). Hence, implied volatility, by default, becomes the only input that changes due to supply and demand. As a result, implied volatility then becomes the valuation metric of the option.
You can think of implied volatility as the "P/E ratio of options". Similar to stocks, when a lot of people buy an option (for whatever reason), the price of that option then goes up. Since all of the other option variables are "fixed", the implied volatility increases as the price of the option increases - and vice versa. So when the implied volatility goes up too much it means you are paying too much for the option.
If you get seriously involved in options you'll find that advanced options traders even quote option prices in terms of volatility (i.e. "The Intel January 55 calls are trading at 24 percent.").
Valuing Implied Volatility
So now that we know that implied volatility is the valuation metric of the option, the next question becomes: "How do we know if the implied volatility is too high or too low?" Well, like any valuation metric there are no objective rules to tell you exactly what the value should be, but there are indicators that you can use as guidelines.
The first indicator you can use is the historical volatility of the underlying security. We calculate the historical volatility by looking at the volatility of the underlying security over the last x days (called the "lookback period"). How many days back should you go? Again, this is subjective. Some say you should use the number of days that the options had left until expiration so that the time frames will be the same. Others say you should use the last 30 days because the most recent activity will the best indicator of the future volatility.
So if the historical volatility of Intel stock is 15% and the Intel options are trading at 25% volatility then the options may be overvalued. The fact that the options' volatility is higher than the stocks' volatility should be a red flag. When this happens the options market is saying that the volatility of Intel stock will be higher in the future (the future being the life of the option) than in the past. The problem with this scenario is that the options' market prediction may turn out to be a correct one - the volatility of Intel stock in the future may indeed rise. So this indicator needs subjective analysis to be useful.
Another indicator you can use to gauge implied volatility is the current historical volatility compared to what the historical volatility has been in the past. This method is based on the premise that there is generally a "normal" level of volatility that a stock will have over time. Therefore, the stock's volatility has an average it tends to trade at and the volatility will tend to be "mean reverting", which means that if volatility becomes too high or too low that it will tend to go back to the average.
For example, if a stock comes out with really bad earnings and the stock drops 50% in one day, the historical volatility of the stock will therefore rise dramatically due to this huge price change. Consequently, the implied volatility of the options will also shoot up because the underlying stock's volatility has. But is historical volatility an accurate gauge of future volatility in this case? In other words, will the underlying stock's volatility stay at this new higher level? Definitely not. Stocks certainly can fall 50% in one day but moves this big will usually occur infrequently. Therefore, it is obvious that the volatility of the stock will go back down as the stock calms down. In this case you can use the past historical volatility of the stock as an accurate guide of where implied volatility will be heading. In this case the volatility of the stock will drop back down. So you will not want to engage in any long-premium strategies because you will be buying at the top of the volatility spike. This is one of the biggest mistakes amateur options traders make. They notice a stock that has moved by a huge amount and then form the hypothesis that the stock is more likely to make a big move now than in the past. Even though this is a correct assumption, they ignore the fact that the option has already baked in this higher likelihood of big price movement by pushing the implied volatility up. More accurately, the option has "overbaked" the likelihood of a big price change because of underlying volatility is at a temporarily high level.
In a case like the one illustrated above you can see how volatility is an accurate valuation metric for an option. As implied volatility rises you are paying more for the exact same option. In other words, the lower the implied volatility, the cheaper the premium is. So when you buy an option you want to have an opinion about what the underlying security will do but it is wise to have an opinion about whether you are paying too for the option. You can think of an option trade as making two different trades at once. The first is betting on the direction of the stock and the second one is betting on the direction of implied volatility. If the implied volatility for an option rises then - everything else being equal - you will make money. If the implied volatility for an option falls then - everything else being equal - you will lose money. The reason most traders don't realize this is because there are so many other variables that are simultaneously affecting the option price (mainly the price of the underlying security) that they don't bother to isolate the volatility factor. Other traders simply don't care. They write off the level of implied volatility of an option as being inconsequential. But it isn't. Volatility is such an important component of the value of an option that some people refer to trading options as "trading volatility".
Another indicator you can use to estimate the correct level of implied volatility of an option is the implied volatility of other options of the same security. This is an example of using "relative valuation" where we are comparing the valuation of similar securities to each other. The danger here is that if all the options for a particular stock are overvalued then this metric won't alert us to that fact.