Implied volatility (IV) indicates the chances of fluctuation in a security’s price. It also helps investors calculate the probability of a price reaching a given mark during a specific time frame.
The difference between implied and historical volatility is that historical volatility, or realized volatility, is the analyzed standard deviation of price movements, while IV is based on the option’s price and shows expected future volatility.
Representation of Implied Volatility
Implied volatility is usually represented as a percentage indicating the expected standard deviation range. Standard deviation (SD) is a concept of statistical probability, and SD is measured as 1 SD, 2 SD, and so on. One standard deviation means that there is about a 68% chance that the price of the option will fall within the expected range, 34% on each side. This range goes in both direction of the scale, so there will be a probability of an increase or decrease in price.
To understand SD ranges for IV, let’s consider the following example. A $300 option has an annualized SD range of 20%. In terms of price fluctuation, the SD range for this stock will be $60.00. In terms of probability, we can say that there is a 68% probability that the price will increase to 360 or decrease to 240. It’s important to mention here that these are theoretical concepts and actual values can move beyond the first, second, and even third standard deviation.
Calculation of Implied Volatility
Different methods are used to determine IV. One such approach is the options pricing theory. This calculation method takes into account variables like interest rate, stock price, expiration, exercise price, and volatility to arrive at a value. At-the-money options (ATM) are the go-to options for calculating implied volatility, as they have the most trading volume in the market. Keep in mind, though, that if the options are liquid, then supply and demand takes precedence over ATM. Investors also use price charts like the CBOE VIX index to estimate expected volatility. The index is based on weighted prices of S&P 500 Index calls and puts spread over a variety of strike prices.
Prediction model for option implied volatility give us a probability of movement, but it does not tell us in which direction this movement will take place. Therefore, all investors must consider the chances of an equal downside to the upside. The option premium depends on the volatility. If the volatility is high, then there is a greater chance of gaining from the investment, so the premium is also high. The opposite is true for low volatility, so the premium will be lower.
Another factor that impacts the volatility rating of an option is the time left to the expiration of that option. If there isn’t enough time left before expiry, then the implied volatility will be low. In contrast, more time means a higher probability of fluctuation in the option’s price.
Video Explaining How To Profit When Volatility Increases
Like other valuation metrics, implied volatility has it’s pros and cons as well. IV helps investors test their estimates for price movement by comparing it with what the market has to say. It also gives investors a basis to create their entry and exit strategy. However, implied volatility is not based on fundamentals, and it can also be affected by unexpected news and events.