Implied Volatility (IV): What It Is & How It's Calculated

Implied volatility is calculated through working out calculations for the various data points that are generally fed into an options pricing ... TableofСontentsWhatIsImpliedVolatility?HowIsImpliedVolatilityCalculated?HowToReadImpliedVolatilityforOptionsWhatIsaHighIVIndexvs.LowIVIndex?IVRank&IVPercentileBenefits&PitfallsofUsingIVPercentagesWhereToFindtheIVofaStockorFundBottomLineExpandImpliedvolatilityisameasureofthedegreeofpricefluctuationsthatinvestorsexpectinagivenstockorotherfinancialassetinthefuture.franckreporter/iStockviaGettyImagesWhatIsImpliedVolatility?Impliedvolatilityisastatisticalmeasureoftheexpectedamountofpricemovementsinagivenstockorotherfinancialassetoverasetfuturetimeframe.TradersuseIVforseveralreasonswhichcaninclude:Asameasurementofriskforagiventradinginstrument.Tocalibratemodelssuchasvalueatrisk(VAR)andtoestablishpositionsizingandlimits.TocalculatefairpricesforoptionscontractsusingmodelssuchastheBlack–Scholesmethod.Totellwhetheranassetiscurrentlyatahighorlowlevelofvolatilitycomparedtoitshistory.Determiningifthemarketasawholeiscurrentlyatahighorlowlevelofsentiment.IVisaninterestingconceptinthatit'sdirectlyusedforthingssuchashelpingsetthepriceofoptionsanddetermineappropriaterisksizingforportfolios.Butitalsoservesasamoregeneralsentimentgaugeonwhereastockorindexisasawhole.Highvolatilitytendstosignalrapidly-changingmarketconditionsandissometimesassociatedwithsharpdeclinesinthevalueofthegivenstockorfinancialassetbeingtracked.TheVIXVolatilityIndexservesaspecificmeasureofimpliedvolatilityfortheS&P500overa30dayspan.ManytradersandmarketpunditslooktotheVIXforaquickmeasureofwhetherthemarketiscalmornervous.TheVIXisjustonewaytotrackvolatilityintheS&P500,however.IV,morebroadly,iscalculatedforamassivenumberofoptionsonstocks,exchange-tradedfunds,currencies,commodities,andsoon.Andknowinghowitworkscanhelpinvestorsmanageriskandtradeoptionsmoreprofitably.HowIsImpliedVolatilityCalculated?ImpliedvolatilityiscalculatedthroughworkingoutcalculationsforthevariousdatapointsthataregenerallyfedintoanoptionspricingmodelsuchasBlack-Scholes.Black-Scholesisafamousmodelthatwaspopularizedin1973fordeterminingpricingofoptionsandothercorporateliabilities.ItssuccesswasinstrumentalindrivingthegrowthoftheoptionsexchangesandeventuallyledtoitsinventorsearningtheNobelPrizeinEconomicSciencesin1997.Atypicalmodelforpricingoptionsmightincludethefollowingdatapoints:PriceoftheoptioninquestionPriceoftheunderlyingstockorfinancialassetinquestionStrikepriceoftheoptionTimeuntiltheoptionexpiresTherisk-freerateofreturn(suchastheinterestrateoftreasurybills)Dividendyield(ifthestockorindexinquestionpaysdividends)Pluggingallofthisdataintothemodelandthencalculatingthroughitwouldspitoutagivenimpliedvolatilityfortheoptioninquestion.Asit'sacompleteformula,otherdatapointscanbesolvedforaswell.Startwithagivenimpliedvolatility,forexample,andthetradercanchangethingssuchasthetimetoexpirytoseehowmuchpricingwouldchange.HowToReadImpliedVolatilityforOptionsGiventhecomplexityincalculatingimpliedvolatilityandoptionspricing,manytraderstendtorelyonExcelformulas,calculators,orbrokeragesoftwaretorunthenumbers.Thatsaid,thereisahandytiptohelpunderstandIVreadingsataglance.It'scalledtheRuleof16.TheRuleof16canhelptradersturncomplicatedIVstatisticsintousefultradinginformation.Volatilityisbasedonstandarddeviations,andisgenerallyexpressedinannualizedterms.However,annualizedvolatilityishardtounderstandinthecontextofshort-termoptions,suchasthoseexpiringinamonth.However,annualizedvolatilitycanbeconvertedintoashorter-termtool.Thetypicaltradingyearhasroughly252daysinit.Thesquarerootof252is15.87,or16whenrounded.Whentheannualizedvolatilityis16,themarketispricingaonestandarddeviationmoveinagivenstocktobea1%tradingrangeperday.Thiswouldmeanthaton68%oftradingdays,thestockshouldmoveupordownlessthan1%95%ofdays,itshouldhavealessthan2standarddeviation(andthus2%)range99.7%oftradingdays,itshouldmovelessthan3%Thiscanserveasausefulrealitycheckforagivenoption.IfastockisquotedatanIVof16,askwhetheritisregularlyhavingbigswingswelloutsideoftheparametersdescribedabove.Ifthat'sthecase,theIVandthusassociatedoptionsmaybemispricedandmayrepresentanopportunityforaprofitabletrade.ButwhataboutoptionswithanIVotherthan16?Inthatcase,theexpectedtradingrangemovesinmultiplesof16.Forexample,AnIVof24wouldimplyanexpecteddailytraderangeof1.5%tobeaone-standarddeviationmove.AnIVof32wouldimplyanexpecteddailytradingrangeof2%.AnIVof48wouldimplyanexpecteddailytraderangeof3%.WhatIsaHighIVIndexvs.LowIVIndex?There'sanimportantdistinctionwhenaddressingthisconcept.EachstockorassethasarangeofIVthatittendstomovebetween.Theselevelsaredeterminedbythegivenvolatilityofthatparticularinstrument.Forexample,insomethinglikeamajorcurrency,IVtendstobeverylow.It'scommontoseeone-monthimpliedvolatilityfiguresforcurrenciessuchastheEurointhesingledigits.Stockmarketindexestendtohaverelativelyhighervolatility;theS&P500,asmeasuredbytheVIX,isofteninthe15-20range.Individualstockstendtohavehighervolatilitiesthantheircorrespondingindexes.That'sbecauseofwhat'sknownassingle-stockrisk.Anyparticularcompanycanhaveakeyemployeeleave,anaccountingscandalhit,atakeoverbeannouncedoranyothersuchsuddendevelopmentwhichcancauseadrasticshort-termchangeinthepriceofsaidstock.Meanwhile,inadiversifiedindexliketheS&P500,theseindividualrisksaremitigatedthroughhavingmanysecuritiesintheunderlyingbasketofholdings.Withinindividualstocks,IVsarealsodistinct.Aspeculativebiotechcompany,forexample,couldeasilyhaveanIVnorthof100whenheadingtowardakeyclinicaltrialreadout.Meanwhile,asleepyutilityorpackagedfoodcompanyislikelytohaveafarlowerIVreading.AnIVfigurebyitselfoftenlackscontext.Assuch,manyinvestorsuserelatedmeasuressuchasIVpercentagestounderstandwhereagiveninstrument'sIViscomparedtoitshistoricalrange.IVRank&IVPercentileOptionstradersoftenlookatIVrankandIVpercentiles,whicharerelativemeasuresbasedontheunderlyingimpliedvolatilityofafinancialasset.IVrankiswhereastock'sIViswithinits52-weekrange.SayastockhashadanIVthatfluctuatedbetween20and40andit'snowat36,itwouldhaveanIVrankof80,sinceitisat80%ofthedistancebetweenits52-weeklowandhigh.IVpercentileisthenumberofdaysoverthepastyearwhereastockhadalowerIVthanithasonthecurrenttradingday.ThisiscalculatedbydividingthenumberofdayswithanIVunderthecurrentonebythenumberofdaysinagiventradingyear.IVpercentileisusefulfordeterminingifvolatilitytendstobehigherorlowerthanwhereitistoday,whereasIVrankgivesasenseofwhereagivenIVfigureiswithinitsbroadtradingrange.Benefits&PitfallsofUsingIVPercentagesProsIVtendstobeamean-revertinginstrument:Volatilityheadsbacktoitsaverageafteratime,creatingopportunitiestoprofitfromextremereadings.IVsvarygreatlybetweenassets:TheIVofanelectriccarcompanymightbemuchdifferentthanabank.IVpercentagesgivemorecontextthanabsoluteIVfigures.IVpercentagesgiveameasurablestatistic:Usingapercentilecantakeemotionoutofatradeasopposedtousinganon-statisticalmethodtodeterminingwhetheranoptionisrichorcheap.ConsLookbackperiodsmatter:Ahistoricalvolatilityrangeover,say,aone-yearperiodwillgiveaverydifferentsenseofpotentialoutcomesifthatperiodincludedablackswaneventsuchastheFinancialCrisisoroutbreakofaglobalpandemic.Holidays:VolatilityonmanyproductsdeclinesaroundholidayssuchasNewYear's,leadingtooptionsbeingcheaperthanduringtherestoftheyear.Weather:Oncommoditiessuchasnaturalgasandagriculturalproducts,certainmonthsoftheyeartendtobefarmorevolatilethanothers.TradesbasedonIVpercentagesmightfailtoaccountforthis.Earnings:Forstocks,IVtendstobehigharoundearningsreports.AtradermayneedtoadjustanIVpercentileorrankreadingifatradeishappeninggoingintoearnings.WhereToFindtheIVofaStockorFundManywebsitesandfinancialscreenersincludetheIVofastockasoneofthekeystatisticsordatapointsthattheydisplay.Somescreenersallowuserstosortbyvolatility,allowingtraderstolookforoptionswhichmaybeparticularlycheaporexpensivetoputtogethertradesaimedatprofitingfromthoseoutliers.Withinmostbrokeragesoftwareapplications,therearetoolstoseetheIVofindividualoptionsonagivenstock,index,orETF.Dependingonthebrokerageplatform,theremaybechartsshowingthevolatilityofvariousoptionsonagivenstockoverdifferentstrikesandexpiries.SomebrokersalsoallowclientstoenterlimitordersbasedongivenIVlevelsaswell,sayingforexampletobuythisoptionifithitsanIVof20orsellitifitreaches40orwhatnot.Note:ManybrokerageshaveIVcalculatorsandvariousrelatedfeaturesbuiltintotheirplatforms.Thesemaybehiddenbydefault,soit'sworthcheckingforadvancedquotations,risknavigators,andtrademodelingsortsoffeatureswithinaplatformwheremanyofthesesomespecializedfunctionsoftenreside.BottomLineImpliedvolatilitycanbeassociatedwithalotofjargonandcomplicatedformulas.Withalittlestudy,however,traderscanlearntoincorporateIVandrelatedconceptsintotheiroptiontradingtomaximizethepotentialreturnsoftheirtrades.ThisarticlewaswrittenbyIanBezek20.64KFollowersFollowAuthorofIan'sInsiderCornerResearchandtradealertsfromahedgefundprowithaglobaloutlook.IanworkedforKerrisdale,aNewYorkactivisthedgefund,forthreeyears,beforemovingtoLatinAmericatopursueentrepreneurialopportunitiesthere.HisIan'sInsiderCornerserviceprovideslivechat,modelportfolios,fullaccessandupdatestohis"IMF"portfolio,alongwithaweeklynewsletterwhichexpandsonthesetopics.Disclosure:I/wehavenostock,optionorsimilarderivativepositioninanyofthecompaniesmentioned,andnoplanstoinitiateanysuchpositionswithinthenext72hours.Iwrotethisarticlemyself,anditexpressesmyownopinions.Iamnotreceivingcompensationforit.Ihavenobusinessrelationshipwithanycompanywhosestockismentionedinthisarticle.RecommendedForYouComments(3)NewestToensurethisdoesn’thappeninthefuture,pleaseenableJavascriptandcookiesinyourbrowser.Isthishappeningtoyoufrequently?Pleasereportitonourfeedbackforum.Ifyouhaveanad-blockerenabledyoumaybeblockedfromproceeding.Pleasedisableyourad-blockerandrefresh.