Understanding this basic question will help you make better decisions when it comes to your options trading.
Take a look at this example;
The red dot in the screen here is a plot of the implied volatility of an option. The curved lines are the actual, volatility paths traded by the underlying stock for the last 6 months, broken down into its' high, low and statistical bands.
The option's implied volatility suggests that the market price for this option is trading at a level well below the historical levels of the stock.
Now, would you buy or sell this option?
Maybe neither...knowing this information could not only provide good trading opportunities but it could also help prevent you from doing a BAD trade.
The screen shot above was taken from a product called the VolCone Analyzer.
VolCone Analyzer downloads historical price data for an instrument and performs volatility analysis over the entire price series to calculate the true, historical volatility bands experienced by the asset over the period analyzed.
Then, it will calculate what the implied volatility is for the option you choose and show you at a glance where the current value fits with the underlying price behavior. Then you can see in an instant if the option is over priced or under priced.
Here's a short video review by Steve from Options University: