how implied volatility iv works
implied volatility iv is essentially a measure of how much the market believes the price of a stock or other underlying asset will move in the future and is a key factor in determining the price of an options contract when traders buy or sell options they re not just gaining exposure to the direction of the stock price but also on how much the price might fluctuate in either direction before the option expires unlike historical volatility which measures past price fluctuations observed in the data implied volatility is forward looking and derived from the current market price of an option as a result implied volatility isn t directly observable in the market instead it must be calculated using an options pricing model like black scholes using such models you would start with the current price of the option and work backwards to determine the level of volatility that would justify that price given all the other known variables inputted into the model traders use implied volatility in a few ways first it helps them gauge whether options prices are relatively cheap or expensive an option with higher implied volatility will be more expensive than an option with low implied volatility all else being equal second some traders try to profit from changes in implied volatility itself they might buy options when implied volatility is low expecting it to rise or sell options when implied volatility is high expecting it to fall third implied volatility is a key input into many risk management models that traders and institutions use to manage their options portfolios finally implied volatility is often used as a heuristic gauge of market sentiment particularly fear and uncertainty when markets are calm and traders are complacent implied volatility tends to be low but when there s a lot of uncertainty or concern about potential risks implied volatility can spike higher one well known example of this is the vix or the cboe volatility index which is a measure of the implied volatility of s p 500 index options the vix is sometimes referred to as the stock market s fear gauge because it tends to spike higher during times of market stress or uncertainty traders watch indicators like the vix closely because spikes in implied volatility can often precede significant market moves implied volatility is not dependent on the direction of the stock price movement but rather on the magnitude of the movement in other words implied volatility doesn t indicate whether the price of the underlying asset is expected to go up or down but instead it measures how much the market believes the price could change in either direction implied volatility and options pricingimplied volatility is one of the key factors used in the pricing of options buying options contracts allow the holder to buy or sell an asset at a specific price during a pre determined period implied volatility approximates the future value of the option and the option s current value is also taken into consideration options with high implied volatility have higher premiums and vice versa keep in mind that implied volatility is based on probability this means it is only an estimate of future prices rather than an actual indication of where they ll go even though investors take implied volatility into account when making investment decisions this dependence can inevitably impact prices themselves there is no guarantee that an option s price will follow the predicted pattern however when considering an investment it does help to consider the actions other investors take with the option and implied volatility is directly correlated with the market opinion which does in turn affect option pricing implied volatility also affects the pricing of non option financial instruments such as an interest rate cap which limits the amount an interest rate on a product can be raised black scholes modelimplied volatility can be determined by using an option pricing model it is the only factor in the model that isn t directly observable in the market instead the mathematical option pricing model uses other factors to determine implied volatility and the option s premium this is a widely used and well known options pricing model factors in current stock price options strike price time until expiration denoted as a percent of a year and risk free interest rates the black scholes model is quick in calculating any number of option prices but the model cannot accurately calculate american options since it only considers the price at an option s expiration date american options are those that the owner may exercise at any time up to and including the expiration day this model uses a binomial tree diagram with volatility factored in at each level to show all possible paths an option s price can take then works backward to determine one price the benefit of the binomial model is that you can revisit it at any point for the possibility of early exercise early exercise is executing the contract s actions at its strike price before the contract s expiration early exercise only happens in american style options however the calculations involved in this model take a long time to determine so this model isn t the best in rushed situations factors affecting implied volatilityjust as with the market as a whole implied volatility is subject to unpredictable changes supply and demand are major determining factors for implied volatility when an asset is in high demand the price tends to rise so does the implied volatility which leads to a higher option premium due to the risky nature of the option the opposite is also true when there is plenty of supply but not enough market demand the implied volatility falls and the option price becomes cheaper another premium influencing factor is the time value of the option or the amount of time until the option expires a short dated option often results in low implied volatility whereas a long dated option tends to result in high implied volatility the difference lays in the amount of time left before the expiration of the contract since there is a lengthier time the price has an extended period to move into a favorable price level in comparison to the strike price pros and cons of using implied volatilityquantifies market sentiment uncertaintyhelps set options pricesdetermines trading strategybased solely on prices not fundamentalssensitive to unexpected factors news eventspredicts movement but not directionimplied volatility helps to quantify market sentiment it estimates the size of the movement an asset may take however as mentioned earlier it does not indicate the direction of the movement option writers will use calculations including implied volatility to price options contracts also many investors will look at the iv when they choose an investment during periods of high volatility they may choose to invest in safer sectors or products implied volatility does not have a basis on the fundamentals underlying the market assets but is based solely on price also adverse news or events such as wars or natural disasters may impact the implied volatility implied volatility standard deviation and expected price changesstandard deviation is a statistical measure that quantifies the amount of variation or dispersion in a set of data in the context of implied volatility standard deviation is used to measure risk in terms of the expected range of potential price moves for the underlying asset in options trading implied volatility is expressed as an annualized percentage for example if options on a stock correspond to an implied volatility of 20 it means the market expects the stock price to move up or down by 20 over the course of a year however this annual implied volatility can be converted into a daily or weekly expectation using standard deviation the general rule of thumb is that here s how this works in practice let s say a stock is trading at 100 and has an annualized implied volatility of 20 to calculate the expected move over the next month you first need to convert the annual volatility to a monthly volatility this is done by dividing the annual volatility by the square root of 12 because there are 12 months in a year and volatility calculations involve taking the square root of time in this case now you can calculate the expected move for each standard deviation level alternatively these calculations suggest that over the next month traders could then use these standard deviation levels to help set their expectations for potential price moves and to assist in strategies like setting stop loss levels or target prices of course these are just statistical probabilities based on the implied volatility actual price moves can and do exceed these expectations especially in the case of unexpected events or news that significantly impacts the market s perception of the stock s value implied volatility examplelet s consider a hypothetical example to illustrate how implied volatility can be used in options trading say abc stock is currently trading at 100 per share the market expects the company to make a significant announcement in a month that could greatly impact the stock price as a result the implied volatility for the stock s options has risen to 40 a call option on abc stock with a strike price of 105 and one month until expiration priced at 2 50 in the market using the black scholes option pricing model we can work backwards to calculate the implied volatility the black scholes model takes into account the following variables plugging these values into an options pricing calculator or using the black scholes formula we would find that the implied volatility is approximately 40 now let s consider two scenarios this example demonstrates how implied volatility can be used by traders to make informed decisions if a trader believes that the market is overestimating the potential for a significant move i e the implied volatility is too high they might choose to sell options conversely if a trader believes that the market is underestimating the potential for a significant move i e the implied volatility is priced too low they might choose to buy options 