What Is Implied Volatility (IV)?

What Is Implied Volatility (IV)?

Let me explain to you what implied volatility, or IV, really is—it's a measure of how much the market thinks the price of a stock or other asset will swing in the future. You can use it to anticipate potential moves, along with supply and demand dynamics, and it's commonly applied to price options contracts.

Don't confuse IV with historical volatility, which is also called realized or statistical volatility; that one looks at past market changes and what actually happened.

Key Takeaways

You should know that IV is frequently used to price options, where high IV means higher premiums and low IV means lower ones. Supply, demand, and time value are the main factors in calculating it. Expect IV to rise in bearish markets and drop in bullish ones. It quantifies market sentiment and uncertainty, but remember, it's based purely on prices, not on fundamentals.

How Implied Volatility (IV) Works

IV plays a central role in setting options contract prices. When you trade options, you're not just betting on the stock's direction but also on how much it might fluctuate before expiration.

Unlike historical volatility, which tracks past fluctuations from data, IV looks ahead and comes from the current market price. You can't observe it directly, so you calculate it with a model like Black-Scholes—start with the option's price and reverse-engineer the volatility that fits, using other known inputs.

I often see IV used as a quick way to measure market sentiment, especially fear and uncertainty. It stays low in calm markets when traders are relaxed, but it spikes during uncertainty or risk concerns.

Take the VIX, the CBOE Volatility Index, for example—it's the IV of S&P 500 options and known as the 'fear gauge' because it jumps during market stress. You should watch it closely, as IV spikes can signal big market shifts.

Important Note on IV

Keep in mind that IV focuses on the size of price movements, not their direction—it doesn't predict if the asset will rise or fall, just how much change the market expects in either way.

How Traders Use Implied Volatility

As a trader, you can use IV to judge if options are cheap or expensive—higher IV makes options cost more than those with lower IV.

Some of you might trade on IV changes directly: buy when IV is low and you expect it to climb, or sell when it's high and likely to drop.

IV is also essential in risk management models for handling options portfolios.

Implied Volatility and Options Pricing

IV is a core element in pricing options, where buying one lets you purchase or sell an asset at a set price within a timeframe. It estimates the option's future value, considering its current price, and high IV leads to higher premiums.

Since IV is probabilistic, it's just an estimate of future prices, not a guarantee. You need to factor it in for decisions, but it can influence prices itself. No pattern is certain, but observing other investors' actions helps. IV ties directly to market opinion, affecting pricing.

IV impacts non-option instruments too, like interest rate caps that limit rate increases.

Options Pricing Models

You determine IV using an options pricing model—it's the only unobservable factor, so the model uses others to find it and the premium.

The Black-Scholes Model

This popular model includes current stock price, strike price, time to expiration as a yearly fraction, and risk-free rates. It's fast for multiple calculations but falls short on American options, as it only looks at expiration-day price.

The Binomial Model

This one uses a tree diagram with volatility at each step to map all price paths, then backtracks to one price. It's great for checking early exercise in American options, but the math takes time, so avoid it in a hurry.

Factors Affecting Implied Volatility

IV changes unpredictably, like the market. Supply and demand drive it—high demand raises prices and IV, boosting premiums due to risk. Low demand with ample supply drops IV and cheapens options.

Time value matters too: short-term options often have low IV, while long-term ones have high IV, giving more time for favorable moves against the strike.

Features and Expectations of Low vs. High Implied Volatilities

With low IV, expect minimal price moves, bullish or sideways sentiment, lower risk, cheaper premiums, and strategies like covered calls or iron condors that thrive on stability—it's a chance to buy cheap options, but surprises can spike volatility. High IV signals big moves, bearish or reactive sentiment, higher risk, expensive premiums, and strategies like straddles or strangles that profit from volatility—it's a selling opportunity, but the big move might not happen.

Pros and Cons of Using Implied Volatility

On the pros side, IV quantifies sentiment and uncertainty, aids in pricing options, and guides strategies. For cons, it's price-based only, not fundamentals, sensitive to news or events, and predicts magnitude but not direction.

Implied Volatility, Standard Deviation, and Expected Price Changes

Standard deviation measures data variation and, with IV, gauges risk via expected price ranges. IV is an annualized percentage; a 20% IV means the market expects 20% up or down over a year.

Convert to daily or weekly using square roots—one SD covers 68% of moves, two SD 95%, three SD 99.7%. For a $100 stock at 20% annual IV, monthly volatility is about 5.77%, so 1SD is $5.77, and so on. This sets probabilities for price stays, helping with stops or targets, though actual moves can exceed due to events.

Implied Volatility Example

Suppose ABC stock trades at $100, with a big announcement expected, pushing IV to 40%. A $105 call expiring in a month costs $2.50. Using Black-Scholes with those inputs, you get about 40% IV.

If actual volatility exceeds 40%, the price rises, profiting buyers; if lower, it falls, profiting sellers. You might sell if IV seems overstated or buy if understated.

How Is Implied Volatility Computed?

IV is in the option's price, so rearrange a model's formula to solve for it, knowing the market price.

How Do Changes in Implied Volatility Affect Options Prices?

Rising IV boosts premiums because higher volatility increases ITM chances. It's tied to extrinsic value, which rises with IV, while intrinsic value depends on moneyness.

Will All Options in a Series Have the Same Implied Volatility?

Not always—downside puts often have higher IV due to hedging demand, creating a volatility skew or 'smile,' unless it's a takeover scenario.

The Bottom Line

IV shows investors' views on future risk and uncertainty in asset movements. You back it out from options prices via models since it's not observable. High IV means big swings expected, low IV means stability. Use it to evaluate sentiment, risks, rewards, and decisions in options trading.