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What is Implied Volatility?

Implied volatility (IV) is one of the most important

concepts for options traders to understand for two

reasons. First, it shows how volatile the market might

be in the future. Second, implied volatility can help you

calculate probability. This is a critical component of

options trading which may be helpful when trying to

determine the likelihood of a stock reaching a specific

price by a certain time. Keep in mind that while these

reasons may assist you when making trading

decisions, implied volatility does not provide a

forecast with respect to market direction. Although

implied volatility is viewed as an important piece of

information, above all it is determined by using an

option pricing model, which makes the data theoretical

in nature. There is no guarantee these forecasts will

be correct.

Understanding IV means you can enter an options trade knowing the markets opinion each time. Too many

traders incorrectly try to use IV to find bargains or over-inflated values, assuming IV is too high or too low. This

interpretation overlooks an important point, however. Options trade at certain levels of implied volatility

because of current market activity. In other words, market activity can help explain why an option is priced in a

certain manner. Here we'll show you how to use implied volatility to improve your trading. Specifically, well

define implied volatility, explain its relationship to probability, and demonstrate how it measures the odds of a

successful trade.

Historical vs. implied volatility

There are many different types of volatility, but options traders tend to focus on historical and implied

volatilities. Historical volatility is the annualized standard deviation of past stock price movements. It measures

the daily price changes in the stock over the past year.

In contrast, IV is derived from an options price and shows what the market implies about the stocks volatility

in the future. Implied volatility is one of six inputs used in an options pricing model, but its the only one that is

not directly observable in the market itself. IV can only be determined by knowing the other five variables and

solving for it using a model. Implied volatility acts as a critical surrogate for option value - the higher the IV, the

higher the option premium.

Since most option trading volume usually occurs in at-the-money (ATM) options, these are the contracts

generally used to calculate IV. Once we know the price of the ATM options, we can use an options pricing

model and a little algebra to solve for the implied volatility.

Some question this method, debating whether the chicken or the egg comes first. However, when you

understand the way the most heavily traded options (the ATM strikes) tend to be priced, you can readily see

the validity of this approach. If the options are liquid then the model does not usually determine the prices of

the ATM options; instead, supply and demand become the driving forces. Many times market makers will stop

using a model because its values cannot keep up with the changes in these forces fast enough. When asked,

What is your market for this option? the market maker may reply What are you willing to pay? This means

all the transactions in these heavily traded options are what is setting the options price. Starting from this

real-world pricing action, then, we can derive the implied volatility using an options pricing model. Hence it is not

the market markers setting the price or implied volatility; its actual order flow.

Implied volatility as a trading tool

Implied volatility shows the markets opinion of the stocks potential moves, but it doesnt forecast direction. If

the implied volatility is high, the market thinks the stock has potential for large price swings in either direction,

just as low IV implies the stock will not move as much by option expiration.

To option traders, implied volatility is more important than historical volatility because IV factors in all market

expectations. If, for example, the company plans to announce earnings or expects a major court ruling, these

events will affect the implied volatility of options that expire that same month. Implied volatility helps you gauge

how much of an impact news may have on the underlying stock.

How can option traders use IV to make more informed trading decisions? Implied volatility offers an objective

way to test forecasts and identify entry and exit points. With an options IV, you can calculate an expected

range - the high and low of the stock by expiration. Implied volatility tells you whether the market agrees with

your outlook, which helps you measure a trades risk and potential reward.

Defining standard deviation

First, lets define standard deviation and how it relates to implied volatility. Then well discuss how standard

deviation can help set future expectations of a stocks potential high and low prices - values that can help you

make more informed trading decisions.

To understand how implied volatility can be useful, you first have to understand the biggest assumption made

by people who build pricing models: the statistical distribution of prices. There are two main types which are

used, normal distribution or lognormal distribution. The image below is of normal distribution, sometimes known

as the bell-curve due to its appearance. Plainly stated, normal distribution gives equal chance of prices

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