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.
BREAKING DOWN '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.
It is important to remember that implied volatility is all probability. It is only an estimate of future prices, rather than an indication of them. Even though investors take implied volatility into account when making investment decisions, and this dependence inevitably has some impact on the 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 are taking in relation to the option, and implied volatility is directly correlated with market opinion, which does in turn affect option pricing.
Another important thing to note is that implied volatility does not predict the direction in which the price change will go. For example, high volatility means a large price swing, but the price could swing very high or very low or both. Low volatility means that the price likely won't make broad, unpredictable changes.
Implied volatility is the opposite of historical volatility, also known as realized volatility or statistical volatility, which measures past market changes and their actual results. It is also helpful to consider historical volatility when dealing with an option, as this can sometimes be a predictive factor in the option's future price changes.
Implied volatility also affects pricing of non-option financial instruments, such as an interest rate cap, which limits the amount by which an interest rate can be raised.
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.
The Binomial Model, on the other hand, uses a tree diagram, with volatility factored in at each level, to show all possible paths an option's price can take, then works backwards to determine one price. The benefit of this model is that you can revisit it at any point for the possibility of early exercise, which means that an option can be bought or sold at its strike price before its expiration. Early exercise occurs only in American options. However, the calculations involved in this model take a long time to determine, so this model isn't best in rush situations.
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.
Another influencing factor is time value of the option, or the amount of time until the option expires, which results in a premium. A short-dated option often results in a low implied volatility, whereas a long-dated option tends to result in a high implied volatility, since there is more time priced into the option and time is more of a variable.
For an investor's guide to implied volatility and a full discussion on options, read Implied Volatility: Buy Low and Sell High, which gives a detailed description of the pricing of options based on the implied volatility.
In addition to known factors such as market price, interest rate, expiration date, and strike price, implied volatility is used in calculating an option's premium. IV can be derived from a model such as the Black Scholes Model.