Implied Volatility (IV)

What is ‘Implied Volatility – IV’

The implied volatility of a security’s price is the projected volatility of the security’s price. When the market is bearish, meaning that investors expect that the asset’s price will drop over time, implied volatility increases, and when the market is bullish, meaning that investors believe that the asset’s price will rise over time, implied volatility reduces.

Due to the widespread notion that negative markets are more dangerous than bullish ones, this is the case. With the use of certain predictive indicators, implied volatility is a method of calculating the future swings in the value of a security’s worth.

Explaining ‘Implied Volatility – IV’

Implied volatility is sometimes referred to as “vol.” Volatility is commonly denoted by the symbol σ (sigma).

Implied Volatility and Options

The implied volatility of an option is one of the elements that determines the price of an option. With high levels of implied volatility come greater premiums for options, which provide the buyer with the chance to purchase or sell an asset at a certain price within a predetermined period of time. The opposite is true for options with low levels of implied volatility.

It is assumed that implied volatility will be close to the future value of an option, and the present value of the option will take this into account. The implied volatility of an option is an important factor for investors to consider; if the price of the option rises, but the buyer owns a call price on the original, lower price, or strike price, that means he or she can pay the lower price and immediately turn around and sell the asset at the higher price if the option price falls.

Option Pricing Models

By utilizing an option pricing model, it is possible to determine implied volatility. There are no direct market observations of this element in the model; instead, the option pricing model makes use of the other factors to estimate implied volatility and call premium.

The Black-Scholes Model, which is the most extensively used and well-known option pricing model, takes into account the current stock price, the strike price of the option, the time to expiry (which is expressed as a percent of a year), and risk-free interest rates. The Black-Scholes Model is extremely efficient when it comes to computing the pricing of a large number of options. However, it is unable to appropriately compute American options since it only takes into account the price at the time of the option’s expiration date.

What Factors Affect Implied Volatility?

Implied volatility, like the rest of the market, is prone to wild swings in price and volume. The relationship between supply and demand is a significant determinant of implied volatility. In the case of a highly demanded asset, the price tends to rise, as does implied volatility, resulting in a greater option premium as a result of the risky character of the option. The inverse is also true: when there is a surplus of supply but insufficient market demand, the implied volatility decreases and the option price decreases.

Affect Implied Volatility FAQ

How does volume affect implied volatility?

An association exists between the volume of trades in a publicly traded stock and its volatility. Stock prices and values rise significantly when big quantities of a stock are acquired; but, when large quantities of a stock are sold a few minutes later, the stock price and value plummet dramatically.

What happens when implied volatility is high?

It is assumed that the stock would experience huge price swings in either direction if implied volatility is high, whereas a low implied volatility indicates that the stock will not move as much at option expiry if implied volatility is low. It is possible to predict how big of an influence news will have on the underlying stock by using implied volatility.

What is considered low implied volatility?

Broad-market Typical volatility for ETFs and utility stocks, for example, is in the range of 10 to 20 points on a scale from one to ten. Healthcare equities and technology businesses may have higher volatility in general, with volatility ranging from 50 to 80 to 100 percent.

Further Reading

  • Volatility in crude oil futures: A comparison of the predictive ability of GARCH and implied volatility models – [PDF]
  • Predicting financial volatility: High‐frequency time‐series forecasts vis‐à‐vis implied volatility – [PDF]
  • Can the evolution of implied volatility be forecasted? Evidence from European and US implied volatility indices – [PDF]
  • The predictive power of implied volatility: Evidence from 35 futures markets – [PDF]
  • The role of implied volatility in forecasting future realized volatility and jumps in foreign exchange, stock, and bond markets – [PDF]
  • The informational content of implied volatility – [PDF]
  • Joint modeling of call and put implied volatility – [PDF]
  • Stock returns, implied volatility innovations, and the asymmetric volatility phenomenon – [PDF]
  • The information content of option-implied volatility for credit default swap valuation – [PDF]
  • Impact of news announcements on the foreign exchange implied volatility – [PDF]