How does implied volatility impact the pricing of options?

Implied volatility is an important aspect of the time value premium of an option. As implied volatility increases, call and put option prices go up. When implied volatility decreases, option prices go down.

Options are financial derivatives that represent a contract by a selling party, or the option writer, to a buying party, or the option holder. An option gives the holder the ability to buy with a call option, or sell in the case of a put option, a financial asset at an agreed price on a specified date or during a specified time period. Holders of call options are looking to profit from an increase in the price of the underlying asset, while holders of put options can generate profits from a price decline. Options are versatile and can be used in a multitude of ways. While some traders use options purely for speculative purposes, other investors, such as those in hedge funds, often utilize options to limit risks attached to holding assets.

In relation to the options market, volatility is a reference to the fluctuation level in the market price of the underlying asset. Volatility is a metric for the speed and amount of movement for underlying asset prices. Cognizance of volatility allows investors to better comprehend why option prices behave in certain ways.

Two common types of volatility affect option prices. Historic volatility, known also as statistical volatility, measures the speed at which underlying asset prices have changed over a given time period. Historical volatility is often calculated annually, but because it constantly changes, historical volatility can also be calculated daily and for shorter time frames. It is important for investors to know the time period for which an option’s historical volatility is calculated. Generally, a higher historical volatility percentage translates to a higher option value.

Implied volatility is a concept specific to options and is a prediction made by market participants of the degree to which underlying securities move in the future. Implied volatility, essentially, is the real-time estimation of an asset’s price as it trades. This provides the predicted volatility of an option’s underlying asset over the entire lifespan of the option, using formulas that measure option market expectations. When option markets experience a downtrend, implied volatility generally increases. Conversely, market uptrends usually cause implied volatility to fall. Higher implied volatility indicates that greater option price movement is expected in the future.

Another dynamic to pricing options, particularly relevant in more volatile markets, is option skew. The concept of option skew is somewhat complicated, but the essential idea behind it is that options with varied strike prices and expiration dates trade at different implied volatilities; the amount of volatility is uniform. Rather, levels of higher volatility are skewed toward occurring more often at certain strike prices or expiration dates.

Every option has an associated volatility risk, and volatility risk profiles can vary dramatically between options. Traders sometimes balance the risk of volatility by hedging one option with another.