What Is Implied Volatility?
The implied volatility (IV) is an important metric, when input in an option pricing model, it will deliver a hypothetical value equal to the current market price of that particular option contract.
Implied volatility is one of the most crucial metrics to learn and understand when trading in options. Apart from options, financial instruments like interest rate cap, which has embedded optionality, can also have implied volatility. Implied volatility is a progressive and subjective metric that is different from historical volatility.
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Understanding The Implied Volatility (IV)
Implied volatility is the stock market’s projection of a likely movement in a stock or a particular security’s price. It is a gauge to measure future volatility of an underlying security price based on few predictive factors, generally used by investors.
It is denoted by symbol σ (sigma), which can frequently be thought to be a substitute for market risk. The IV is commonly represented using percentages and standard deviations over a specified period of time.
For the stock market, The IV generally increase in bearish markets, when investors think stock prices will dip over time. Generally, Implied volatility (IV) decreases during a bullish market, and investors think that the stock prices will surge over time. This happens because the bearish market is unpredictable, thus volatility increases significantly rather than the bullish market.
Usually, the implied volatility does not forecast the direction in which the price change moves. For instance, higher volatility means a large price swing, but the price could upward or downward or range-bound fluctuate between the two top points. A lower volatility means the stock price likely swing too much.
How Implied Volatility Affects Options Pricing?
As you know, the options price depends upon two things, the intrinsic value and the time value. The intrinsic value is the real value of an option contract. The time value adds some premium to the options contract depending upon the time left for the expiry, stock’s price, strike price, interest rate, and the implied volatility.
Implied volatility is a very important deciding factor in options pricing. Buying an options contract means it lets the investor buy or sell an underlying asset at a specific price with a pre-determined time called the expiration date. The IV approximates the projected value of the option contract, and the option’s current price is also taken into factor.
Options contracts with higher implied volatility will have higher premiums and vice versa. It is essential to remember that IV is based on the probability. It on estimates of future prices rather than an implication of them.
Investors can think implied volatility as a price and use the advanced technical analysis tools to measure and forecast the implied volatility. One of the most popular tools to measure the IV is the volatility index (VIX), which is a real-time market index. It helps to judge and to forecast the implied volatility.
Factors Affecting Implied Volatility
- Supply and demand are important deciding factors for implied volatility. When a stock is in huge demand, the stock price tends to rise. So does the IV, which leads to a higher option price. When there is a higher supply but not enough demand, the implied volatility drops, and the option price gets cheaper.
- Another important factor is the time value of the options contract, the number of days left until the expiration. A lower-period option often results have low implied volatility, whereas longer-period options have high implied volatility.
Importance of Implied Volatility
- The implied volatility expresses the market sentiment and defines the future movement of the market and helps traders to manage the uncertainty during options trading.
- The options price also depends upon the volatility and moves higher with an increase in volatility and vice-versa.
- There are several options trading strategies out there, that is determined by the volatility.
Limitations of Implied Volatility
- It is based only on prices, not on the fundamentals, so prediction is quite difficult for the traders.
- The volatility is sensitive to unexpected news and events and to keep track of it for a normal trader is quite difficult.
- It only predicts the movement of the security, but not the direction of it.
After reading this I hope you understand how important implied volatility is while selecting option strategies, expiration months, or strike prices. Along with this, you should also make use of a few easy volatility forecasting methods, that will help you avoid overpriced options contracts.