How Implied Volatility (IV) Works With Options and Examples

Definition

The term implied volatility refers to a metric that captures the market's view of the likelihood of future changes in a given security's price.

What Is Implied Volatility (IV)?

The term implied volatility refers to a metric that captures the market's view of the likelihood of future changes in a given security's price. Investors can use implied volatility to project future moves and supply and demand, and often employ it to price options contracts. Implied volatility isn't the same as historical volatility (also known as realized volatility or statistical volatility), which measures past market changes and their actual results.

Key Takeaways

Implied volatility is the market's forecast of a likely movement in a security's price.
IV is often used to price options contracts where high implied volatility results in options with higher premiums and vice versa.
Supply and demand and time value are major determining factors for calculating implied volatility.
Implied volatility usually increases in bearish markets and decreases when the market is bullish.
Although IV helps quantify market sentiment and uncertainty, it is based solely on prices rather than fundamentals.

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 Pricing

Implied 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 Model

Implied 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.

Binomial Model

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 Volatility

Just 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.

Features and Expectations of Low vs. High Implied Volatilities
Aspect	Low IV	High IV
Market Expectation	Minimal price movement	Significant price movement
Market Sentiment	Bullish or sideways	Bearish or reactive
Risk Perception	Lower risk environment	Higher risk environment
Options Premiums	Less expensive	More expensive
Potential Trading Opportunities	Favor strategies like covered calls, iron condors, and spreads that benefit from stability. Buying opportunity for cheap options.	Favor strategies like straddles, strangles, and spreads that benefit from volatility. Selling opportunity for expensive options

Low IV doesn't guarantee that the price will remain stable, and unexpected events can suddenly cause volatility; High IV means that buying options is more expensive, and there's a greater risk of the stock making a big move, however this may never materialize.

Pros and Cons of Using Implied Volatility

Pros

Quantifies market sentiment, uncertainty
Helps set options prices
Determines trading strategy

Cons

Based solely on prices, not fundamentals
Sensitive to unexpected factors, news events
Predicts movement, but not direction

Implied 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 Changes

Standard 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:

One standard deviation (1SD) encompasses about 68% of the expected price move.
Two standard deviations (2SD) encompass about 95% of the expected price move.
Three standard deviations (3SD) encompass about 99.7% of the expected price move.

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:

Monthly Volatility = 20% / √12 ≈ 5.77%

Now, you can calculate the expected move for each standard deviation level:

1SD Move = $100 * 5.77% ≈ $5.77
2SD Move = $100 * 5.77% * 2 ≈ $11.55
3SD Move = $100 * 5.77% * 3 ≈ $17.32

Alternatively, these calculations suggest that over the next month:

There's about a 68% probability that the stock will stay within $5.77 of its current price.
There's about a 95% probability that the stock will stay within $11.55 of its current price.
There's about a 99.7% probability that the stock will stay within $17.32 of its current price.

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 Example

Let'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:

Current stock price: $100
Strike price: $105
Time to expiration: 1 month (assume 30 days for simplicity)
Risk-free interest rate: 1% (0.01)
Option price: $2.50

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:

If the actual volatility of the stock over the next month turns out to be higher than 40%, the option price will likely increase, assuming all other factors remain constant. In this case, the option buyer would profit from the difference in implied and realized volatility.
If the actual volatility of the stock over the next month turns out to be lower than 40%, the option price will likely decrease, assuming all other factors remain constant. In this case, the option buyer would lose (and the seller would profit).

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.

How Does Implied Volatility Work?

Implied volatility measures the market's expectation of future price fluctuations for a financial instrument, such as a stock or option. It is derived from the market price of options and reflects investors' perceptions of uncertainty or risk associated with the underlying asset's future movements.

Historical Volatility vs. Implied Volatility

Historical volatility (HV) and implied volatility (IV) are both measures of volatility in the price of an underlying asset, but they differ in their perspective. Historical volatility looks at past price movements, while implied volatility looks forward, representing the market's expectations for future price movements. Despite these differences, there is a relationship between the two. This is because implied volatility is often influenced by historical volatility. When historical volatility has been high, market participants may expect that trend to continue, leading to higher implied volatility. Conversely, when historical volatility has been low, implied volatility may also be lower. However, implied volatility is not solely determined by historical volatility. It also incorporates the market's expectations about future events that could impact the underlying asset's price. The difference between historical volatility and implied volatility is sometimes referred to as the "volatility risk premium."

How Is Implied Volatility Computed?

Since implied volatility is embedded in an option's price, one needs to re-arrange an options pricing model's formula to solve for volatility instead of the price (since the current price is known in the market).

How Do Changes in Implied Volatility Affect Options Prices?

Regardless of whether an option is a call or put, its price, or premium, will increase as implied volatility increases. This is because an option's value is based on the likelihood that it will finish in-the-money (ITM). Since volatility measures the extent of price movements, the more volatility there is the larger future price movements ought to be and, therefore, the more likely an option will finish ITM.

The relationship between an option's extrinsic value and implied volatility is, therefore, key to understanding option pricing. Extrinsic value, also known as time value, is the portion of an option's price that is not intrinsic value (i.e., the difference between the underlying asset's price and the option's strike price, which represents the amount an option is in-the-money). Extrinsic value is directly influenced by implied volatility. Higher IV leads to higher extrinsic value, while lower IV results in lower extrinsic value. At the same time, an option's intrinsic value is not related to IV--only to its moneyness.

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

No, not necessarily. Downside put options tend to be more in demand by investors as hedges against losses. As a result, these options are often bid higher in the market than a comparable upside call (unless the stock is a takeover target). As a result, there is more implied volatility in options with downside strikes than on the upside. This is known as the volatility skew or "smile."

The Bottom Line

Implied volatility (IV) reflects investors' perceptions of uncertainty or risk associated with the future movements of the underlying asset. This differs from historical volatility, which is observed by looking at past price action. Because it cannot be directly observed, IV must be backed out of options prices using pricing models. High implied volatility generally indicates greater expected price swings. Low implied volatility suggests the market anticipates relatively stable prices. Traders and investors use implied volatility to assess market sentiment, gauge the potential risks and rewards of trading options, and better investment decisions.