Implied Volatility (IV)

Implied volatility is the market's forecast of the likely movement in a security's price and is often used to price that security's option contracts. Investors can use it to project future market volatility with varying levels of confidence which can greatly aid in evaluating an option's price.

Implied volatility is the market's view of what will happen to a given security's price in the future. It is a metric used by investors to estimate future fluctuations (volatility) of a security's price based on certain predictive factors. Implied volatility, denoted by the symbol σ (sigma), can often be thought to be a proxy of market risk. It is commonly expressed using percentages and standard deviations over a specified time horizon.

Generally speaking, with respect to equity markets, implied volatility increases in bearish markets, when investors believe 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 partly due to the fact that bearish markets are considered to be undesirable, hence riskier, to the majority of equity investors.

Implied volatility is one of the deciding factors in the pricing of options. Options, which give the buyer an opportunity to buy or sell an asset at a specific price during a pre-determined period of time, with high implied volatility will have higher premiums and vice versa. Implied volatility approximates the future value of an option, and the option's current value takes this into consideration.

It is important to remember that implied volatility is based on 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 point 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, very low, or both. Low volatility means that the price likely won't make broad, unpredictable changes.

Implied volatility is not the same as historical volatility, also known as realized volatility or statistical volatility. Historical volatility measures past market changes and their actual results. Still, it is 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.

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 the option's premium. The Black-Scholes Model, a 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 backward 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 the best in rushed situations.

Just as with the market as a whole, implied volatility is subject to unpredictable 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 the time value of the option, or the amount of time until the option expires. A short-dated option often results in low implied volatility, whereas a long-dated option tends to result in high implied volatility, since there is more time priced into the option and time is more of a variable.