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 the future changes of a security’s price.
Investors sometimes use implied volatility as a way to understand the level of market risk they face. They calculate the implied volatility of a security using either the Black-Scholes model or the Binomial model.
What Is Volatility?
Volatility, as it relates to investments, is the pace at which the market price of a security moves up or down during a given period. During times of high volatility, prices experience frequent, large swings.
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What Is Implied Volatility?
Implied volatility is, in essence, a prediction, based on probability. While it shapes the price of an option, it does not guarantee that the price activity of the underlying security will indeed 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 does 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 expect equity prices to go down.
During bull markets on the other hand, investors implied volatility tends to go down as more investors 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. Options implied volatility can also help options traders decide whether and when to exercise their option.
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 options forecast the size of the price change investors 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 can also help investors determine whether they want to charge or pay an options premium for a security. Options on underlying securities that have high implied volatility come with higher premiums, while options on securities with lower implied volatility command lower premiums.
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Implied Volatility and Other Financial Products
Implied volatility impacts 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 is a major factor in the prices that people pay for those caps.
How Is Implied Volatility Calculated?
There are two implied volatility formulas that investors typically use.
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 developed the model in 1973.
It is a complex mathematical equation investors use as a way of projecting the price changes over time for financial instruments, including stocks, futures contracts, and options contracts. Investors use the Black-Scholes Model to forecast 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 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 to accurately calculating 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 day.
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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 can be exercised at any point before their expiration date.
Invented in 1979, the binomial model uses the very simple 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 new information arises. In comparison with other models, the binomial option pricing model is very simple at first, but becomes extremely complex as it accounts for multiple time periods.
By using the binomial model with multiple periods of time, a trader can use an implied volatility chart to visualize the 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 new market news emerges.
The calculations involved in the binomial model can take a long time to complete, which makes it difficult for short-term traders to utilize.
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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 translates to 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 will have lower implied volatility than one with a longer duration. And 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 estimate the size of the price movement that a particular asset may experience.
• During periods of high volatility, implied volatility can help investors choose safer 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 entirely on the security’s price.
• Implied volatility does not account for unexpected adverse events that can affect the security, its price and its implied volatility in the future.
The Takeaway
Investors use implied volatility to predict the changes in security prices that increase the odds of success. It is a useful indicator but it has limitations, so investors may want to use it in connection with other types of analysis.
Volatility is a fairly high-level concept as it relates to the markets, and given that there are different types of volatility, it may be beyond most investors’ ability to properly use as a part of a larger strategy. That said, having a basic understanding of implied volatility can be useful for nearly all investors.
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