Implied Volatility (IV) Definition - Investopedia

Implied volatility is the market's forecast of a likely movement in a security's price. It is a metric used by investors to estimate future fluctuations ( ... TableofContents Expand TableofContents WhatIsImpliedVolatility? HowImpliedVolatilityWorks IVandOptions IVandOptionPricingModels FactorsAffectingImpliedVolatility ProsandCons Real-WorldExample Trading OptionsandDerivatives WhatIsImpliedVolatility(IV)? Thetermimpliedvolatilityreferstoametricthatcapturesthemarket'sviewofthelikelihoodofchangesinagivensecurity'sprice.Investorscanuseimpliedvolatilitytoprojectfuturemovesandsupplyanddemand,andoftenemployittopriceoptionscontracts.Impliedvolatilityisn'tthesameashistoricalvolatility(alsoknownasrealizedvolatilityorstatisticalvolatility),whichmeasurespastmarketchangesandtheiractualresults. KeyTakeaways Impliedvolatilityisthemarket'sforecastofalikelymovementinasecurity'sprice.IVisoftenusedtopriceoptionscontractswherehighimpliedvolatilityresultsinoptionswithhigherpremiumsandviceversa.Supplyanddemandandtimevaluearemajordeterminingfactorsforcalculatingimpliedvolatility.Impliedvolatilityusuallyincreasesinbearishmarketsanddecreaseswhenthemarketisbullish.AlthoughIVhelpsquantifymarketsentimentanduncertainty,itisbasedsolelyonpricesratherthanfundamentals. HowImpliedVolatility(IV)Works Impliedvolatilityisthemarket'sforecastofalikelymovementinasecurity'sprice.Itisametricusedbyinvestorstoestimatefuturefluctuations(volatility)ofasecurity'spricebasedoncertainpredictivefactors.Impliedvolatilityisdenotedbythesymbol σ (sigma).Itcanoftenbethoughttobeaproxyofmarketrisk.Itiscommonlyexpressedusingpercentagesandstandarddeviationsoveraspecifiedtimehorizon. Whenappliedtothestockmarket,impliedvolatilitygenerallyincreasesinbearishmarkets,wheninvestorsbelieveequitypriceswilldeclineovertime.IVdecreaseswhenthemarketisbullish.Thisiswheninvestorsbelievepriceswillriseovertime.Bearishmarketsareconsideredtobeundesirableandriskiertothemajorityofequityinvestors. IVdoesn'tpredictthedirectioninwhichthepricechangewillproceed.Forexample,highvolatilitymeansalargepriceswing,butthepricecouldswingupward(veryhigh),downward(verylow),orfluctuatebetweenthetwodirections.Lowvolatilitymeansthatthepricelikelywon'tmakebroad,unpredictablechanges. ImpliedVolatilityandOptions Impliedvolatilityisoneofthedecidingfactors inthepricingofoptions.Buyingoptionscontractsallowtheholdertobuyorsellanassetataspecificpriceduringapre-determinedperiod.Impliedvolatilityapproximatesthefuturevalueoftheoption,and theoption'scurrentvalueisalsotakenintoconsideration.Optionswithhighimpliedvolatilityhavehigherpremiumsandviceversa. Keepinmindthatimpliedvolatilityisbasedon probability.Thismeansitisonlyanestimateoffutureprices ratherthananactualindicationofwherethey'llgo.Eventhoughinvestorstakeimpliedvolatilityintoaccountwhenmakinginvestmentdecisions,thisdependencecaninevitablyimpactpricesthemselves. Thereisnoguaranteethatanoption'spricewillfollowthepredictedpattern.However,whenconsideringaninvestment, itdoeshelptoconsidertheactionsotherinvestorstakewiththeoption,andimpliedvolatilityisdirectlycorrelatedwiththemarketopinion,whichdoes,inturn,affectoptionpricing. Impliedvolatilityalsoaffectsthepricingofnon-optionfinancialinstruments,suchasaninterestratecap,whichlimitstheamountaninterestrateonaproductcanberaised. ImpliedVolatilityandOptionPricingModels Impliedvolatilitycanbedeterminedbyusinganoptionpricingmodel.Itistheonlyfactorinthemodel thatisn'tdirectlyobservableinthemarket.Instead,themathematicaloptionpricingmodelusesotherfactorstodetermineimpliedvolatilityandthe option'spremium. Black-ScholesModel Thisisawidelyusedandwell-knownoptionspricingmodel,factorsin currentstockprice,optionsstrikeprice,timeuntilexpiration(denotedasapercentofayear),andrisk-freeinterestrates.TheBlack-Scholes Modelisquickincalculatinganynumberofoptionprices. ButthemodelcannotaccuratelycalculateAmericanoptions,sinceitonlyconsidersthepriceatanoption'sexpirationdate.Americanoptionsarethosethattheownermayexerciseatanytimeuptoandincludingtheexpirationday. BinomialModel Thismodelusesatreediagram withvolatilityfactoredinateachlevel toshowallpossiblepathsanoption'spricecantake,thenworksbackwardtodetermineoneprice.ThebenefitoftheBinomialModelisthatyoucanrevisititatanypointforthepossibilityofearlyexercise. Earlyexerciseisexecutingthecontract'sactionsatitsstrikepricebeforethecontract'sexpiration.Earlyexercise onlyhappensinAmerican-styleoptions.However,thecalculationsinvolvedinthismodeltakealongtimetodetermine,sothismodelisn'tthebestinrushedsituations. FactorsAffecting ImpliedVolatility Justaswiththemarketasawhole,impliedvolatilityissubjecttounpredictablechanges.Supplyanddemandaremajordeterminingfactorsforimpliedvolatility.Whenanassetisinhighdemand,thepricetendstorise.Sodoestheimpliedvolatility,whichleadstoahigheroptionpremiumduetotheriskynatureoftheoption. Theoppositeisalsotrue.Whenthereisplentyofsupplybutnotenoughmarketdemand,theimpliedvolatilityfalls, andtheoptionpricebecomescheaper. Anotherpremiuminfluencingfactoristhe timevalueoftheoption,ortheamountoftimeuntiltheoptionexpires.Ashort-datedoptionoftenresultsinlowimpliedvolatility,whereasalong-datedoptiontendstoresultinhighimpliedvolatility.Thedifferencelaysintheamountoftimeleftbeforetheexpirationofthecontract.Sincethereisalengthiertime,thepricehasanextendedperiodtomoveintoafavorablepricelevelincomparisontothestrikeprice. ProsandConsofUsingImpliedVolatility Impliedvolatilityhelpstoquantifymarketsentiment.Itestimatesthesizeofthemovementanassetmaytake.However,asmentionedearlier,itdoesnotindicatethedirectionofthemovement.Optionwriterswillusecalculations,includingimpliedvolatility,topriceoptionscontracts.Also,manyinvestorswilllookattheIVwhentheychooseaninvestment.Duringperiodsofhighvolatility,theymaychoosetoinvestinsafersectorsorproducts. Impliedvolatilitydoesnothaveabasisonthefundamentalsunderlyingthemarketassets,butisbasedsolelyonprice.Also,adversenewsoreventssuchaswarsornaturaldisastersmayimpacttheimpliedvolatility. Pros Quantifiesmarketsentiment,uncertainty Helpssetoptionsprices Determinestradingstrategy Cons Basedsolelyonprices,notfundamentals Sensitivetounexpectedfactors,newsevents Predictsmovement,butnotdirection Real-WorldExample Tradersandinvestorsusechartingtoanalyzeimpliedvolatility.OneespeciallypopulartoolistheCboeVolatilityIndex(VIX).CreatedbytheCboeGlobalMarkets,theVIXisareal-timemarketindex.Theindexusespricedatafromnear-dated,near-the-moneyS&P500indexoptionstoprojectexpectationsforvolatilityoverthenext30days. InvestorscanusetheVIXtocomparedifferentsecuritiesortogaugethestockmarket'svolatilityasawhole,andformtradingstrategiesaccordingly. WhyIsImpliedVolatilityImportant? Futurevolatilityisoneoftheinputsneededforoptionspricingmodels.Thefuture,however,isunknown.Theactualvolatilitylevelsrevealedbyoptionspricesarethereforethemarket'sbestestimateofthoseassumptions.Ifsomebodyhasadifferentviewonfuturevolatilityrelativetotheimpliedvolatilityinthemarket,theycanbuyoptions(iftheythinkfuturevolatilitywillbehigher)orselloptions(ifitwillbelower). HowIsImpliedVolatilityComputed? Sinceimpliedvolatilityisembeddedinanoption'sprice,oneneedstore-arrangeanoptionspricingmodelformulatosolveforvolatilityinsteadoftheprice(sincethecurrentpriceisknowninthemarket). HowDoChangesinImpliedVolatilityAffectOptionsPrices? Regardlessofwhetheranoptionisacallorput,itsprice,orpremium,willincreaseasimpliedvolatilityincreases.Thisisbecauseanoption'svalueisbasedonthelikelihoodthatitwillfinishin-the-money(ITM).Sincevolatilitymeasurestheextentofpricemovements,themorevolatilitythereisthelargerfuturepricemovementsoughttobeand,therefore,themorelikelyanoptionwillfinishITM. WillAllOptionsinaSeriesHavetheSameImpliedVolatility? No,notnecessarily.Downsideputoptionstendtobemoreindemandbyinvestorsashedgesagainstlosses.Asaresult,theseoptionsareoftenbidhigherinthemarketthanacomparableupsidecall(unlessthestockisatakeovertarget).Asaresult,thereismoreimpliedvolatilityinoptionswithdownsidestrikesthanontheupside.Thisisknownasthevolatilityskewor"smile." ArticleSources Investopediarequireswriterstouseprimarysourcestosupporttheirwork.Theseincludewhitepapers,governmentdata,originalreporting,andinterviewswithindustryexperts.Wealsoreferenceoriginalresearchfromotherreputablepublisherswhereappropriate.Youcanlearnmoreaboutthestandardswefollowinproducingaccurate,unbiasedcontentinour editorialpolicy. SouthDakotaStateUniversity,OpenPRAIRIE."Multi-StepForecastoftheImpliedVolatilitySurfaceUsingDeepLearning,"Page16. TDAmeritradeLearningCenter."ImpVolatility." UniversityofOxford."TheBinomialTreeModel:ASimpleExampleofPricingFinancialDerivatives." CboeGlobalMarkets."VIXVolatilitySuite." UniversityofOxford."TheBinomialTreeModel:ASimpleExampleofPricingFinancialDerivatives,"Page7. CompareAccounts AdvertiserDisclosure × TheoffersthatappearinthistablearefrompartnershipsfromwhichInvestopediareceivescompensation.Thiscompensationmayimpacthowandwherelistingsappear.Investopediadoesnotincludealloffersavailableinthemarketplace. 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