Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
Table of Contents
Implied volatility (IV) is a metric that describes the market’s expectation of future movement in the price of a security. Implied volatility, also known by the symbol σ (sigma), employs a set of predictive factors to forecast how volatile a security’s price may be.
Some investors may use implied volatility as a way to understand the level of market risk they may face. Implied volatility is often calculated using either the Black-Scholes model or the Binomial model.
Key Points
• Implied volatility measures expected future price movement, reflecting market sentiment.
• High implied volatility suggests larger price swings, which can significantly impact options premiums.
• Implied volatility may be calculated using the Black-Scholes and Binomial models, each with specific applications.
• Elevated market risk can be signaled through implied volatility, though it doesn’t indicate which direction prices may move.
• Limitations include the inability to predict future direction, account for unexpected events, and reflect fundamental value.
What Is Volatility?
Volatility, as it relates to investments, is the pace and extent that the market price of a security may move up or down during a given period. During times of high volatility, prices experience frequent, large swings, while periods of low volatility see fewer and smaller price changes.
What Is Implied Volatility?
Implied volatility is, in essence, a metric used in options trading that reflects the market’s anticipation of a security’s future price movements, rather than its historical performance. While it informs the price of an option, it does not guarantee that the price activity of the underlying security will be as volatile, or as stable, as the expectation embedded in its implied volatility. While implied volatility isn’t a window onto the future, it can often correlate with the broader opinion that the market holds regarding a given security.
To express implied volatility, investors typically use a percentage that shows the rate of standard deviation over a particular time period. As a measure of market risk, investors typically see the highest implied volatility during downward-trending or bearish markets, when they may expect equity prices to go down.
During bull markets on the other hand, implied volatility tends to go down as more investors may believe equity prices will rise. That said, as a metric, implied volatility doesn’t predict the direction of the price swings, only that the prices are likely to swing.
How Implied Volatility Affects Options
So how does implied volatility affect options? When determining the value of an options contract, implied volatility is a major factor. Implied volatility can help options traders evaluate an option’s price and also evaluate whether the option may be a good fit for their strategy.
An investor buying options contracts has the right, but not the obligation, to buy or sell a particular asset at an agreed-upon price during a specified time period. Because IV helps estimate the extent of the price change investors may expect a security to experience in a specific time span, it directly affects the price an investor pays for an option. It would not help them determine whether they want a call or a put option.
It may also be used by some traders to help them determine whether they want to charge or pay an options premium for a security. Options on underlying securities that have high implied volatility tend to come with higher premiums, while options on securities with lower implied volatility typically command lower premiums.
Recommended: Popular Options Trading Terminology to Know
Implied Volatility and Other Financial Products
Implied volatility can also impact the prices of financial instruments other than options. One such instrument is the interest rate cap, a product aimed at limiting the increases in interest charged by variable-rate credit products.
For example, homeowners might purchase an interest rate cap to limit the risks associated with their variable-rate mortgages and adjustable-rate mortgage (ARM) loans. Implied volatility may be a consideration in the prices that borrowers may pay for those interest rate caps.
How Is Implied Volatility Calculated?
There are two implied volatility formulas that some investors typically use to estimate fair option pricing based on market conditions.
Black-Scholes Model
One of the most widely used methods of calculating implied volatility is the Black-Scholes Model. Sometimes known as the Black-Scholes-Merton model, the Black-Scholes model is named for three economists who published the model in a journal in 1973.
It can be a complex mathematical equation investors use to project potential price changes over time for financial instruments, including stocks, futures contracts, and options contracts. Investors use the Black-Scholes Model to estimate the value of different securities and financial derivatives. When used to price options, it uses the following factors:
• Current stock price
• Options contract strike price
• Amount of time remaining until the option expires
• Risk-free interest rates
The Black-Scholes formula takes those known factors and effectively back-solves for the value of implied volatility.
The Black-Scholes Model offers a quick way to calculate European-style options, which can only be exercised at their expiration date, but the formula is less useful for accurately pricing American options, since it only considers the price at an option’s expiration date. With American options, the owner may exercise at any time up to and including the expiration date.
Binomial Model
Many investors consider the binomial option pricing model more intuitive than the Black-Scholes model. It also represents a more effective way of calculating the implied volatility of U.S. options, which may be exercised at any point before (and on) their expiration date.
Invented in 1979, the binomial model uses the assumption that at any moment, the price of a security will either go up or down.
As a method for calculating the implied volatility of an options contract, the binomial pricing model uses the same basic data inputs as Black-Scholes, along with the ability to update the equation as market conditions change or new information becomes available. In comparison with other models, the binomial option pricing model is very simple at first. It can become extremely complex, however, as it accounts for many time periods and supports early exercise for pricing American-style options.
By using the binomial model with multiple periods of time, a trader can use an implied volatility chart to visualize potential changes in implied volatility of the underlying asset over time, and evaluate the option at each point in time. It also allows the trader to update those multi-period equations based on each day’s price movements and emerging market news.
The calculations involved in the binomial model can take a long time to complete, which may make it difficult for short-term traders to use.
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What Affects Implied Volatility?
The markets fluctuate, and so does the implied volatility of any security. As the price of a security rises, that can change its implied volatility, which can influence changes in the premium it costs to buy an option.
Another factor that changes the implied volatility priced into an option is the time left until the option expires. An option with a relatively near expiration date tends to have lower implied volatility than one with a longer duration. As an options contract grows closer to its expiration, the implied volatility of that option tends to fall.
Implied Volatility Pros and Cons
There are both benefits and drawbacks to be aware of when using implied volatility to evaluate a security.
Pros
• Implied volatility can help an investor quantify the market sentiment around a given security.
• Implied volatility can help investors estimate the size of the price movement that a particular asset may experience.
• During periods of high volatility, implied volatility can help investors identify potentially lower-risk sectors or products.
Cons
• Implied volatility cannot predict the future.
• Implied volatility does not indicate the direction of the price movement a security is likely to experience.
• Implied volatility does not factor in or reflect the fundamentals of the underlying security, but is based primarily on the security’s price.
• Implied volatility does not account for unexpected adverse events that could affect the price of the security and its implied volatility in the future.
The Takeaway
Some investors use implied volatility to assess expected price movement and evaluate option value. It can be a useful indicator, but it has limitations. Investors may want to use it in connection with other types of analysis to better contextualize risk and potential price behavior.
That said, having a basic understanding of implied volatility can be a helpful foundation for nearly all investors.
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With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.
FAQ
What is implied volatility?
Implied volatility measures the extent and frequency that the market expects a security’s price to move. Options traders may use it to evaluate whether premiums are relatively expensive or inexpensive, and to help them gauge strategy timing.
Is high IV good for options?
High implied volatility can work in favor of option sellers, since they may collect a higher premium for those options. Option buyers typically pay more upfront for an option with high implied volatility, but the potential for bigger price swings may increase the likelihood that the option will move into the money, though this comes with higher risk, as well.
How can I try to profit from implied volatility?
Traders may try to profit by buying options ahead of events that are likely to trigger sharp price moves, hoping the option’s value rises. Others may sell options when IV is high to collect larger premiums, expecting volatility may drop. Both strategies hinge on timing and carry risk.
What is the function of implied volatility?
Implied volatility reflects how much price movement the market anticipates for a given security. It helps determine options pricing and offers a snapshot of perceived risk, but it doesn’t predict the direction that the security’s price may move.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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