In short:
Implied volatility (IV) is a metric used to quantify the market’s anticipation of a securities price movement. IV, however, does not indicate the direction of the anticipated move, rather the magnitude of the move which can be in either direction.
IV can be valuable to traders as it may both help quantify riskiness around different securities and is an important factor in determining the price (called premium) of an options contract. For options contracts, the higher the IV the higher the premium as the likelihood of the option ending up in the money increases.
Key Points
- Implied volatility (IV) is a metric that quantifies the market’s anticipation of price movement for a security.
- Bearish markets tend to experience greater IV than bullish markets.
- IV is used to help price options contracts where greater IV results in higher premiums.
In-depth:
Understanding How Implied Volatility (IV) Works
Implied volatility (IV) is a metric that allows traders to quantify the market’s anticipation of a securities price movement. The metric is valuable only in the sense that it can give an idea of the anticipated magnitude of change but not the directionality of the change.
Additionally, the factors that go into calculating IV are not based on the fundamentals of the underlying security. Instead, IV relies on inputs such as supply and demand and price movement to determine its value.
IV is typically represented using either a percentage or a standard deviation. For example, say we are looking at a stock trading at $75/share. If we then look at the stock’s IV and see it is 25%, what we can conclude is currently the stock has a 68% chance of trading in the range of $56.25 to $93.25 over the course of the next year. That is, this trading range represents 1 standard deviation away from the stock’s current price.
The simple way to interpret this is the higher the IV the more the market is anticipating big swings in a securities price.
Using Implied Volatility in Options
So, can we use an implied volatility number like the one from above when applying it to our options analysis?
Not quite.
The IV number like the one we used above is on a yearly timeframe, meaning the 25% price volatility could happen at any point over an entire year. When buying or selling options, typically traders do not buy options whose expiration is an entire year away. Instead, they may buy options with only 30, 15, or fewer days until expiration.
To account for this difference in time, we must adjust the IV number to reflect the appropriate timeframe. For example, say we the security from above with 25% IV and are looking at an option on this security with only 15 days remaining. We adjust as follows:
- Divide 365 by the days remaining: 365/15 = 24.33
- Take the square root of 24.33: (24.33)^1/2 = 4.93
- Divide IV by 4.93: 25%/4.93 = 5.07%
- The IV for the option with 15 days remaining is 5.07%
This means the underlying security for this option has a 68% chance to trade between the range of $71.20 and $78.80. The two things to keep in mind about implied volatility are that IV is not static, it changes every day, and the underlying price could still trade outside of this range, there is only a 68% chance it stays between this range.
Historical Volatility vs Implied Volatility
If implied volatility is the market’s anticipation of the price movement in a securities price, historical volatility is what has actually happened.
No metric is perfect, and sometimes metrics give us hard to believe numbers to go off. This is why traders or investors may look to historical volatility to add context to market behavior. For example, if the IV for a particular security is especially high, a trader may look to see if this is outside the norm for the security.
Implied Volatility & VIX Connection
What if investors wanted to have a more high-level broad view of the implied volatility for the market at large? That is, if an investor wanted to know if they can expect wider trading ranges for many stocks.
For this, investors turn to the Chicago Board of Options Exchange Volatility Index (VIX) which shows expectations for 30-day volatility. To calculate the VIX, the implied volatilities of options contracts on companies that compose the S&P 500 are used.
Typically, the VIX is low during bull markets (10 – 25) and high during bear markets (30 – 60+).