Implied Volatility

Let’s turn our attention to Implied Volatility, which, compared to Historical Volatility, can be somewhat more challenging to get our minds around. Implied Volatility (IV) is a calculation made by market makers and other professionals using mathematical models to determine how volatile an option’s price will be in the near to intermediate future. In short, it is the market’s expectation of future volatility for any given option. Therefore, it is a gauge of the mood of the market to a particular stock or option.

You can get a qualitative feel for IV by thinking about the expected price behavior of two different stocks. Compare a plain-vanilla slow-moving utility company to a fast-paced internet startup company. Which one do you think will have the most variation in price over the next few days, weeks and months? You probably suspect that the internet company will likely have to most variation in price, that is to say, will be the more volatile of the two. So, in your own qualitative way of thinking, the internet company will have a higher IV than the utility.

Why is the expected future volatility of an option or stock referred to as “implied” volatility? As mentioned, IV is calculated by using theoretical option pricing models, such as Black-Scholes, to compute the price for an option on an asset from a small number of other variables. IV results from treating volatility as the unknown, then using market price to solve for volatility. Thus it is “implied” by the mathematical model used to calculate it.

What can affect IV? Some of the biggest factors include company earnings reports, bad news about a company’s products or prospects, adverse economic and geopolitical reports and the like. IV can vary tremendously for some assets. Take drug stocks for example: An upcoming announcement by the Food and Drug Administration can increase the IV for a small drug company whose promising product is about to be evaluated.

Keep in mind that IV can be and is often different that Historical Volatility. IV will tend to be high when fear, negativity, or uncertainly grip a market. It will tend to be low when the market expects smooth sailing ahead. IV can be tremendously useful for safe options sellers. We will explore this in the next section on Options Volatility Trading.

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