Understanding Implied Volatility (IV): A Comprehensive Guide

Implied volatility (IV) uses the price of an option to calculate what the market is saying about the future volatility of the option’s underlying stock. IV is one of six factors used in options pricing modelsOption Pricing ModelsOption Pricing Models are mathematical models that use certain variables to calculate the theoretical value of an option. The theoretical value of an; however, it can’t be calculated unless the remaining five factors are already known. Ultimately, implied volatility is important because it acts as a sort of alternate measure for the actual value of the option. The option premium is higher when the IV is higher.

With volatility, trading volume is critical. Options trading volume is typically highest for at-the-money (ATM) option contracts; thus, they are generally used to calculate IV. Once the price of the ATM options has been determined, an options pricing model can be used to determine IV. Implied volatility is generally reported as a percentage, with standard deviationsStandard DeviationFrom a statistics standpoint, the standard deviation of a data set is a measure of the magnitude of deviations between values of the observations contained over a period of time.

Summary: 

• Implied volatility (IV) is a metric used to forecast what the market thinks about the future price movements of an option’s underlying stock.
• IV is useful because it offers traders a general range of prices that a security is anticipated to swing between and helps indicate good entry and exit points.
• IV is affected by a number of factors, with the most significant being supply and demand and time value.

Using Implied Volatility as a Trading Tool

It’s important to understand that for investors, implied volatility is important because it provides insight into what the market thinks about a stock’s price movement – whether the movements will be large, moderate, or small. However, IV doesn’t forecast the direction in which the movements will occur.

Implied volatility differs from historical volatility (HV) in that, as the latter’s name suggests, historical volatility gives insight about future movements based solely on past movements. While HV is helpful, traders typically find IV more useful because it takes into account past movements and all market expectations.

A trader can use IV to calculate an expected range for an option throughout its life. It points out the anticipated highs and lows for the option’s underlying stock and indicates potentially good entry and exit points for the trader. Ultimately, IV will reveal whether the market agrees with a trader’s speculations and help him decide how risky a trade is and whether the reward is worth the investment.

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What Affects Implied Volatility

Implied volatility is affected by many of the same factors that affect the general market. Two of the primary factors that affect IV are supply and demandSupply and DemandThe laws of supply and demand are microeconomic concepts that state that in efficient markets, the quantity supplied of a good and quantity. Prices typically rise in response to assets that are in high demand. Also, prices typically fall when assets aren’t as desired. IV also increases with demand, leading to a higher premium because the option has been deemed as having a greater chance to pay off.

When demand is lagging, prices and IV tend to decrease. It means that the supply of the asset is healthy, but the market isn’t seeking it as aggressively. When the price and IV drop, the option is deemed more of a risk, and therefore the premium is lower.

Time value is the other primary factor that affects IV. Time value is the length of time left before the option reaches its expiration date. A low IV is closely tied to options with short expiration periods; options with longer expiration periods tend to have higher IV. Why?

Keeping in mind that IV indicates the swing of movement, but not the direction, the longer the period of time before expiration, the longer the stock needs to move either in or out of the trader’s favor, making it riskier but also offering greater potential to prove profitable eventually.

Additional Resources

CFI is the official provider of the global Capital Markets & Securities Analyst (CMSA)®Program Page - CMSAEnroll in CFI's CMSA® program and become a certified Capital Markets &Securities Analyst. Advance your career with our certification programs and courses. certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

• Convertible Bonds Overview
• Market Risk PremiumMarket Risk PremiumThe market risk premium is the additional return an investor expects from holding a risky market portfolio instead of risk-free assets.
• Intermediate Swaps
• VIXVIXThe Chicago Board Options Exchange (CBOE) created the VIX (CBOE Volatility Index) to measure the 30-day expected volatility of the US stock market, sometimes called the "fear index". The VIX is based on the prices of options on the S&P 500 Index