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Implied Volatility (IV)

Implied Volatility (IV)

What is 'Implied Volatility - IV'

Implied volatility is the estimated volatility of a security's price. In general, implied volatility increases when the market is bearish, when investors believe that the asset's price will decline over time, and decreases when the market is bullish, when investors believe that the price will rise over time. This is due to the common belief that bearish markets are riskier than bullish markets. Implied volatility is a way of estimating the future fluctuations of a security's worth based on certain predictive factors.

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

Implied volatility is one of the deciding factors in the pricing of options. Options, which give the buyer the opportunity to buy or sell an asset at a specific price during a pre-determined period of time, have higher premiums with high levels of implied volatility, and vice versa. Implied volatility approximates the future value of an option, and the option's current value takes this into consideration. Implied volatility is an important thing for investors to pay attention to; 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 the asset around and sell it at the higher price.

Option Pricing Models

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; rather, the option pricing model uses the other factors to determine implied volatility and call premium. The Black-Scholes Model, the most 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. However, it cannot accurately calculate American options, since it only considers the price at an option's expiration date.

What Factors Affect Implied Volatility?

Just like the market as a whole, implied volatility is subject to capricious changes. Supply and demand is a major determining factor for implied volatility. When a security is in high demand, the price tends to rise, and so does 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.


Further Reading

Volatility in crude oil futures: A comparison of the predictive ability of GARCH and implied volatility modelsVolatility in crude oil futures: A comparison of the predictive ability of GARCH and implied volatility models
www.sciencedirect.com [PDF]
… Also Implied Volatility (IV) can be computed by using a number of approaches, depending on the models used … model, ie using the BS model to obtain IV for American options; the volatility being a … Using the BS model to value American options is believed to imply a pricing error …

Predicting financial volatility: High‐frequency time‐series forecasts vis‐à‐vis implied volatilityPredicting financial volatility: High‐frequency time‐series forecasts vis‐à‐vis implied volatility
onlinelibrary.wiley.com [PDF]
… Also Implied Volatility (IV) can be computed by using a number of approaches, depending on the models used … model, ie using the BS model to obtain IV for American options; the volatility being a … Using the BS model to value American options is believed to imply a pricing error …

Can the evolution of implied volatility be forecasted? Evidence from European and US implied volatility indicesCan the evolution of implied volatility be forecasted? Evidence from European and US implied volatility indices
www.sciencedirect.com [PDF]
… Also Implied Volatility (IV) can be computed by using a number of approaches, depending on the models used … model, ie using the BS model to obtain IV for American options; the volatility being a … Using the BS model to value American options is believed to imply a pricing error …

The predictive power of implied volatility: Evidence from 35 futures marketsThe predictive power of implied volatility: Evidence from 35 futures markets
www.sciencedirect.com [PDF]
… Also Implied Volatility (IV) can be computed by using a number of approaches, depending on the models used … model, ie using the BS model to obtain IV for American options; the volatility being a … Using the BS model to value American options is believed to imply a pricing error …

The role of implied volatility in forecasting future realized volatility and jumps in foreign exchange, stock, and bond marketsThe role of implied volatility in forecasting future realized volatility and jumps in foreign exchange, stock, and bond markets
www.sciencedirect.com [PDF]
… Also Implied Volatility (IV) can be computed by using a number of approaches, depending on the models used … model, ie using the BS model to obtain IV for American options; the volatility being a … Using the BS model to value American options is believed to imply a pricing error …

The informational content of implied volatilityThe informational content of implied volatility
academic.oup.com [PDF]
… Also Implied Volatility (IV) can be computed by using a number of approaches, depending on the models used … model, ie using the BS model to obtain IV for American options; the volatility being a … Using the BS model to value American options is believed to imply a pricing error …

Joint modeling of call and put implied volatilityJoint modeling of call and put implied volatility
www.sciencedirect.com [PDF]
… Also Implied Volatility (IV) can be computed by using a number of approaches, depending on the models used … model, ie using the BS model to obtain IV for American options; the volatility being a … Using the BS model to value American options is believed to imply a pricing error …

Stock returns, implied volatility innovations, and the asymmetric volatility phenomenonStock returns, implied volatility innovations, and the asymmetric volatility phenomenon
www.jstor.org [PDF]
… Also Implied Volatility (IV) can be computed by using a number of approaches, depending on the models used … model, ie using the BS model to obtain IV for American options; the volatility being a … Using the BS model to value American options is believed to imply a pricing error …

The information content of option-implied volatility for credit default swap valuationThe information content of option-implied volatility for credit default swap valuation
www.sciencedirect.com [PDF]
… Also Implied Volatility (IV) can be computed by using a number of approaches, depending on the models used … model, ie using the BS model to obtain IV for American options; the volatility being a … Using the BS model to value American options is believed to imply a pricing error …

Impact of news announcements on the foreign exchange implied volatilityImpact of news announcements on the foreign exchange implied volatility
www.sciencedirect.com [PDF]
… Also Implied Volatility (IV) can be computed by using a number of approaches, depending on the models used … model, ie using the BS model to obtain IV for American options; the volatility being a … Using the BS model to value American options is believed to imply a pricing error …


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