Implied Volatility (IV)

What is implied volatility?

Implied volatility (IV) is the market’s estimate of how much the price of an underlying asset (stock, ETF, index, etc.) is expected to move over a given period. It is expressed as an annualized percentage and reflects expected magnitude of price change — not direction. Higher IV = larger expected swings and higher option premiums; lower IV = smaller expected swings and cheaper premiums.

How IV is derived

IV is not directly observable. It is backed out of an option’s market price by reversing an option-pricing model (e.g., Black‑Scholes or a binomial model) to find the volatility input that makes the model price equal to the observed market price. Because it’s implied by prices, IV embeds market sentiment, supply/demand for options, and expectations about future uncertainty.

Key uses for traders

• Price assessment — determine whether options are relatively cheap or expensive.
• Strategy selection — choose buying vs. selling strategies based on whether IV looks low or high relative to expectations.
• Volatility trading — profit from changes in IV (buy options when IV is low, sell when IV is high).
• Risk management — IV is a key input in hedging and portfolio risk models.

IV and option pricing

IV is a primary driver of an option’s extrinsic (time) value. All else equal:
* Rising IV → higher extrinsic value → option premiums increase.
* Falling IV → lower extrinsic value → option premiums decrease.

Intrinsic value depends only on moneyness (price vs. strike); IV affects only the time value portion. Changes in IV therefore move option prices even if the underlying price stays the same.

Common pricing models

• Black‑Scholes: Fast, widely used for European-style options. Solves option price from inputs; IV is found by inverting the formula numerically. Not ideal for early exercise features (American options).
• Binomial model: Builds a recombining tree of possible price paths, handles early exercise and more complex features but is computationally heavier.

Factors that affect implied volatility

• Supply and demand for options — higher demand (e.g., hedging interest) tends to raise IV.
• Time to expiration — longer-dated options typically have higher IV because there’s more time for price movement.
• Market events/news — earnings, economic releases, geopolitical events, or crises increase uncertainty and IV.
• Underlying-specific risks — liquidity, takeover rumors, or concentrated investor positions can skew IV.

Volatility skew / smile

IV typically varies across strikes and expirations:
* Skew (or smile) — puts and out‑of‑the‑money options often show different IVs than calls, reflecting asymmetric demand (e.g., hedging downside risk).
* Term structure — IV can differ by expiration date, producing upward or downward sloping volatility curves.

IV, standard deviation, and expected moves

IV can be converted into expected price move ranges using standard-deviation assumptions:

Convert annual IV to period IV:
* Period volatility ≈ Annual IV × √(period_fraction), or reversed: Period IV = Annual IV / √(time_units_per_year).
Example: Annual IV = 20% → Monthly IV ≈ 20% / √12 ≈ 5.77%

Expected moves around current price (approximate):
* ±1 SD ≈ 68% probability
* ±2 SD ≈ 95% probability
* ±3 SD ≈ 99.7% probability

Illustration:
* Stock price = $100, annual IV = 20% → monthly move (1 SD) ≈ $5.77.
– 1 SD: $100 ± $5.77
– 2 SD: $100 ± $11.55
– 3 SD: $100 ± $17.32

Practical example

If options market prices imply 40% annualized IV for a stock with a pending announcement, market participants expect larger near-term swings. A one-month call priced in the market reflects that IV. If realized volatility over the month exceeds implied volatility, option buyers tend to profit; if realized volatility is lower, option sellers benefit. Traders decide to buy or sell options based partly on whether they believe IV is mispriced relative to expected realized volatility.

Pros and cons of using IV

Pros
* Quantifies market uncertainty and sentiment.
* Helps price options and select trading strategies.
* Useful input for risk and position management.

Cons
* Derived from prices — it reflects market consensus, not fundamentals.
* Sensitive to news and sudden events; can change rapidly.
* Predicts magnitude of moves but not direction.

Quick takeaways

• IV measures expected magnitude of future price moves, not direction.
• It’s calculated by inverting option-pricing models to match observed option prices.
• Higher IV → higher option premiums and greater expected swings; lower IV → cheaper premiums and calmer expectations.
• Traders use IV to assess option value, choose strategies, and manage risk, but it should be combined with fundamental and event-driven analysis.

Further action

Use IV alongside other metrics (delta, theta, vega, historical volatility, and event calendars) to form a more complete view when trading or hedging with options.