Implied Volatility - IV

Loading the player...

DEFINITION of '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 more risky 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 "vols." 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.

RELATED TERMS
  1. Golden Cross

    A crossover involving a security's short-term moving average ...
  2. Warrant

    A derivative that confers the right, but not the obligation, ...
  3. Swap

    A derivative contract through which two parties exchange financial ...
  4. Bull Call Spread

    An options strategy that involves purchasing call options at ...
  5. Board Of Directors - B Of D

    A group of individuals that are elected as, or elected to act ...
  6. After-Hours Trading - AHT

    Trading after regular trading hours on the major exchanges. The ...
Related Articles
  1. Mutual Funds & ETFs

    PHDG: PowerShares S&P 500 Downside Hedged ETF

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  2. Investing Basics

    What is Meant by Implied Volatility?

    The estimated volatility of a security's price.
  3. Options & Futures

    Volatility's Impact On Market Returns

    Find out how to adjust your portfolio when the market fluctuates to increase your potential return.
  4. Options & Futures

    Options Basics Tutorial

    Discover the world of options, from primary concepts to how options work and why you might use them.
  5. Options & Futures

    The Ins And Outs Of Selling Options

    Selling options can seem intimidating but with these tips, you can enter the market with confidence.
  6. Options & Futures

    The ABCs Of Option Volatility

    The mystery of options pricing can often be explained by a look at implied volatility (IV).
  7. Investing News

    Latest Labor Numbers: Good News for the Market?

    Some economic numbers are indicating that the labor market is outperforming the stock market. Should investors be bullish?
  8. Investing News

    Is the White House too Optimistic on the Economy?

    Are the White House's economic growth projections for 2016 and 2017 realistic or too optimistic?
  9. Products and Investments

    Cash vs. Stocks: How to Decide Which is Best

    Is it better to keep your money in cash or is a down market a good time to buy stocks at a lower cost?
  10. Economics

    Can the Market Predict a Recession?

    Is a bear market an indication that a recession is on the horizon?
RELATED FAQS
  1. What is the relationship between implied volatility and the volatility skew?

    The volatility skew refers to the shape of implied volatilities for options graphed across the range of strike prices for ... Read Full Answer >>
  2. How is implied volatility for options impacted by a bearish market?

    Implied volatility for options increases during a bearish market. A bearish market is considered to have more risk than a ... Read Full Answer >>
  3. Why is the Volatility Ratio important for traders and analysts?

    The volatility ratio was designed to tell traders when the price of a security breaks out of its true range. When the ratio ... Read Full Answer >>
  4. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  5. What is after-hours trading? Am I able to trade at this time?

    After-hours trading (AHT) refers to the buying and selling of securities on major exchanges outside of specified regular ... Read Full Answer >>
  6. Do hedge funds invest in commodities?

    There are several hedge funds that invest in commodities. Many hedge funds have broad macroeconomic strategies and invest ... Read Full Answer >>
Hot Definitions
  1. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  2. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  3. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  4. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  5. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center