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Implied volatility is a concept used in option pricing that represents the expected volatility of the option’s underlying asset over the life of the option. It’s the major component of the premium above the intrinsic value of the option’s total price.

For instance, if an investor owns a $100 call option on ABC stock that is trading at $110, the investor can buy ABC stock at the $100 strike price, then turn around and sell it in the market at $110 for a $10 profit.  This profit represents the intrinsic value inherent in the option’s price.  If that call option is currently trading for $15, then the call option has an additional $5 of premium built into its price.  Many variables, such as the risk-free interest rate and time to maturity, affect the premium part of the option price, but implied volatility affects it the most.

The option’s premium price component changes as the expectations of volatility change over time.  These expectations are influenced by supply and demand of the option’s underlying asset and market expectations of its price directions. If expectations go up or demand increases, implied volatility goes up, which leads to an increase in the option’s premium price component. Conversely, if market expectations decrease or demand drops, implied volatility goes down, as does the premium.

Each option has its own unique sensitivity to changes in implied volatility.  Option traders use their analysis of an option’s implied volatility to determine the best trading strategy for that particular option. 

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