What is implied volatility?

Implied volatility (IV) is a measure of the market’s expectations for future price fluctuations in the price of an option’s underlying asset, typically a stock or an index. It provides investors with a general range of prices that an asset is expected to fluctuate between and can be used to identify entry and exit points.

Implied volatility is influenced by various factors, including supply and demand and an option’s time value. Higher implied volatility suggests greater uncertainty and potential for large price movements, while lower implied volatility indicates more stability.

What is implied volatility in options trading?

Implied volatility (IV) in options trading measures how much the market expects an underlying asset’s future prices to fluctuate. It is a key input in options pricing models and reflects the level of anticipated volatility over the option's life.

When traders engage in options trading, they’re not just speculating on the direction of the stock price but also on how much the price could fluctuate before the option's expiration. This makes implied volatility a key component in calculating an option’s premium. Generally, higher implied volatility corresponds to higher option prices as it suggests greater uncertainty or expected movement in the underlying asset.

Unlike historical volatility, which reflects past price movements, implied volatility is forward-looking and based on an option’s current prices. This means it cannot be directly observed in the market and must be derived from an options pricing model, such as the Black-Scholes model. These models look at five factors when pricing an option:

• Current stock price or underlying asset price
• Strike price
• Time to expiration
• Risk-free interest rate
• Implied volatility.

Implied volatility cannot be calculated unless the first four variables are known. To calculate IV, investors start with the current market price of an option, usually for at-the-money (ATM) contracts since they have the highest trading volumes. This price is inputted into the options pricing model to calculate implied volatility. IV is expressed as an annualized percentage and represents the market’s expectations of future price fluctuations, based on standard deviation over the option's time frame.

How does implied volatility influence investment decision-making?

Implied volatility plays an important role in investment decision-making by providing insights into market expectations, helping identify entry and exit points, evaluating options pricing, and more.

Understand market expectations

Implied volatility measures the market’s expectations of how much an asset’s price might move over a given period. However, it doesn’t indicate the direction of the movement.

Investors can use this insight to assess the potential risk and rewards of a particular asset. For example, higher implied volatility suggests that significant price movements are expected. This might indicate higher risk but also the potential of greater rewards. Lower implied volatility, on the other hand, shows that the market anticipates smaller price movements, which might appeal to more conservative investors.

Identify entry and exit points

Investors can use implied volatility to estimate an expected price range of an underlying asset throughout the life of an option. This helps them determine potential highs and lows of the underlying stock, which can guide decisions about when to enter or exit a trade.

Determine options pricing

Implied volatility directly influences the pricing of options. Options with higher implied volatility have higher premiums because the potential for significant price movements increases their value. Understanding implied volatility can help investors assess whether an option is relatively cheap or overpriced compared to its historical volatility and market conditions.

Capitalize on IV changes

Some investors develop strategies to profit from changes in implied volatility itself. For example, they may buy options when IV is low, anticipating an increase, or sell options when IV is high, expecting a decrease. Strategies like straddles or strangles are specifically designed to benefit from large price fluctuations or shifts in volatility.

Gauge market sentiment

Implied volatility is often considered a barometer of market sentiment, particularly when it comes to fear or uncertainty. Low IV typically signals calm and stable market conditions, while high IV indicates heightened uncertainty or fear.

One example of this is the VIX (CBOE Volatility Index), which measures the implied volatility of S&P 500 index options. Investors monitor these indicators for spikes in implied volatility, which can suggest significant market movements ahead.

What factors affect implied volatility?

Implied volatility is influenced by various factors, many of which affect the general market as a whole. These include:

Supply and demand

Like other financial assets, supply and demand play a significant role in determining an option’s price and its implied volatility:

• High demand: When there’s strong demand for an option, its price tends to rise, which is typically reflected in higher implied volatility. This is because higher demand often signals that market participants expect significant price movements in the underlying asset.
• Low demand: When demand for an option is low, its price and implied volatility often decrease.

However, the relationship between demand and implied volatility isn’t always direct. Market implied volatility is mostly driven by market expectations of future volatility and price movements rather than the option’s current price or trading activity.

Time value

An option’s time value, or time to expiration, also impacts implied volatility. Options with shorter expiration periods often have lower implied volatility because there’s less time for the underlying asset’s price to swing significantly.

Options with longer expiration periods, on the other hand, tend to have higher implied volatility. The longer the time to expiration, the more potential there is for the price to move.

What is the difference between implied volatility and historical volatility?

Implied and historical volatility are both used to measure volatility in an underlying asset’s price, however they differ in terms of perspective. Implied volatility is forward-looking and estimates future price movements based on an option’s current prices. Historical volatility, on the other hand, focuses on past price movements (often called realized volatility).

The two are closely connected, however. If realized volatility has been high, market participants might expect the pattern to continue – which leads to higher implied volatility. When historical volatility has been low, on the other hand, implied volatility might also decrease.

That said, implied volatility isn’t just driven by historical volatility, it also reflects the market’s expectations of future events that could affect the underlying stock price movements. The difference between implied volatility and historical volatility is sometimes called the ‘volatility risk premium’.

How are options prices connected to implied volatility?

Options are priced based on the probability that the underlying asset will finish in-the-money (ITM) or with intrinsic value by expiration. The higher the likelihood of this outcome, the more expensive the option becomes. This probability is heavily influenced by IV, as implied volatility increases the chances of significant price movements.

The greater the implied volatility, the higher the likelihood of significant price swings, which increases the probability of an option finishing ITM. For that reason, options with higher implied volatility tend to have higher premiums as there’s an increased likelihood of profitable price changes.

Why implied volatility is a key factor in assessing market sentiment

Implied volatility is a key factor in assessing market sentiment because it represents the market’s expectations of future price fluctuations. When implied volatility is high, it means that investors are anticipating significant price movements over the life of the option. This expectation generally comes from factors like uncertainty, upcoming events, or broader market conditions that could disrupt the asset’s price.

For example, if a company is about to announce earnings or there’s geopolitical instability, investors might anticipate these events to cause big swings in a stock’s price. The demand for options might increase as a result, and the prices of those options will also rise, which leads to higher implied volatility.

High IV reflects increased uncertainty or risk in the market. Since options derive their value from the potential for future price changes, an increase in volatility directly increases the possibility of an option becoming ITM due to a significant price movement.

Low IV, on the other hand, often signals market stability and investors don’t expect significant price changes. In this case, there’s less demand for options, leading to lower premiums and therefore lower implied volatility.

For investors, implied volatility can act as a barometer of market sentiment by providing insight into how much risk the market perceives in the near future. Traders often focus on vanilla options when gauging market sentiment as the influence of IV on their pricing is more straightforward.

How businesses assess risk using implied volatility metrics

Implied volatility can help businesses assess risk by providing an indication of how the market expects an option's future price to fluctuate. Higher implied volatility suggests increased uncertainty and the potential for large price swings, which signals higher risk. Lower implied volatility, however, indicates expectations of stability and reduced risk.

Tracking implied volatility metrics of assets they’re involved with can help companies adjust their risk management strategies and make more informed decisions about investments and hedging.

This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.