How Implied Volatility (IV) Works With Options and Examples

What Is Implied Volatility (IV)?

The term implied volatility refers to a metric that captures the market's view of the likelihood of future changes in a given security's price. Investors can use implied volatility to project future moves and supply and demand, and often employ it to price options contracts. Implied volatility isn't the same as historical volatility (also known as realized volatility or statistical volatility), which measures past market changes and their actual results.

How Implied Volatility (IV) Works

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 (volatility) of a security's price based on certain predictive factors. Implied volatility is denoted by the symbol σ (sigma). It can often be thought to be a proxy of market risk. It is commonly expressed using percentages and standard deviations over a specified time horizon.

When applied to the stock market, implied volatility generally increases in bearish markets, when investors believe equity prices will decline over time. IV decreases when the market is bullish. This is when investors believe prices will rise over time. Bearish markets are considered to be undesirable and riskier to the majority of equity investors.

IV doesn't predict the direction in which the price change will proceed. For example, high volatility means a large price swing, but the price could swing upward (very high), downward (very low), or fluctuate between the two directions. Low volatility means that the price likely won't make broad, unpredictable changes.

Implied Volatility and Options

Implied volatility is one of the deciding factors in the pricing of options. Buying options contracts allow the holder to buy or sell an asset at a specific price during a pre-determined period. Implied volatility approximates the future value of the option, and the option's current value is also taken into consideration. Options with high implied volatility have higher premiums and vice versa.

Keep in mind that implied volatility is based on probability. This means it is only an estimate of future prices rather than an actual indication of where they'll go. Even though investors take implied volatility into account when making investment decisions, this dependence can inevitably impact prices themselves.

There is no guarantee that an option's price will follow the predicted pattern. However, when considering an investment, it does help to consider the actions other investors take with the option, and implied volatility is directly correlated with the market opinion, which does, in turn, affect option pricing.

Implied Volatility and 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. Instead, the mathematical option pricing model uses other factors to determine implied volatility and the option's premium.

Black-Scholes Model

This is a 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.

But the model cannot accurately calculate American options, since it only considers the price at an option's expiration date. American options are those that the owner may exercise at any time up to and including the expiration day.

Binomial Model

This model uses a tree diagram with volatility factored in at each level to show all possible paths an option's price can take, then works backward to determine one price. The benefit of the Binomial Model is that you can revisit it at any point for the possibility of early exercise.

Early exercise is executing the contract's actions at its strike price before the contract's expiration. Early exercise only happens in American-style options. However, the calculations involved in this model take a long time to determine, so this model isn't the best in rushed situations.

Factors Affecting Implied Volatility

Just as with the market as a whole, implied volatility is subject to unpredictable changes. Supply and demand are major determining factors for implied volatility. When an asset is in high demand, the price tends to rise. So does the 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.

Another premium influencing factor is the time value of the option, or the amount of time until the option expires. A short-dated option often results in low implied volatility, whereas a long-dated option tends to result in high implied volatility. The difference lays in the amount of time left before the expiration of the contract. Since there is a lengthier time, the price has an extended period to move into a favorable price level in comparison to the strike price.

Pros and Cons of Using Implied Volatility

Implied volatility helps to quantify market sentiment. It estimates the size of the movement an asset may take. However, as mentioned earlier, it does not indicate the direction of the movement. Option writers will use calculations, including implied volatility, to price options contracts. Also, many investors will look at the IV when they choose an investment. During periods of high volatility, they may choose to invest in safer sectors or products.

Implied volatility does not have a basis on the fundamentals underlying the market assets, but is based solely on price. Also, adverse news or events such as wars or natural disasters may impact the implied volatility.

Real-World Example

Traders and investors use charting to analyze implied volatility. One especially popular tool is the Cboe Volatility Index (VIX). Created by Cboe Global Markets, the VIX is a real-time market index. The index uses price data from near-dated, near-the-money S&P 500 index options to project expectations for volatility over the next 30 days.

Investors can use the VIX to compare different securities or to gauge the stock market's volatility as a whole, and form trading strategies accordingly.