I bought $5 MELA put 2 weeks ago and MELA was trading at $6.80.  The price has gone up to $7.40 and we have lost 10 days of time decay.  Yet, MELA's option price has increased.  It's volatility has gone from 410 to 577.  There are 7 days left till expiration.  How should I interpret such a rise in volatility and how do other members take volatility into account when trading options?

Dricha,

Great question. Implied Volatility (IV) is a measure of risk. The higher the IV the higher the risk and reward.

Take for example MELA vs. GE for the 11/20 Expiration

1. MELA at $7.00 a share, the $2.00 strike which is 71% Out of the Money has a 2.5% ROI and the IV is at 500%.  This tells you if you could sell a put 71% out of the money and get 2.5% return the risk is high, but you have to weigh that with a 72% downside protection. Will the stock fall 72% in 10 days?  Here is where the next step is to do a little more research to see if the company is at risk of going out of business. Check analyst option on the stock. If you have access to stock research at your brokerage this is a good place to look.  This helps one to make the call if taking the risk is a good play or not.

2. GE at 16.62 a share the only put that has an ROI is the 17 strike and it is In the money. The ROI is only .72% and the IV is 25%.  Low Risk/Low Reward and in this case a 69% Probability of Assignment (POA) means the option seller will own the stock at expiration.