What we'll cover
What implied volatility is and how it works
How implied volatility is calculated
Why implied volatility matters to options traders
While it’s not as effective as a crystal ball, implied volatility can offer investors insight into how likely it is that a security’s price will move up or down. In options trading, the metric is often used to price options contracts.
Understanding implied volatility and how it is calculated can help you develop an effective options trading strategy.
How does implied volatility work?
Broadly speaking, implied volatility is used to forecast potential movements of stock prices. But it’s not an exact predictor of which way a stock’s price will go or how widely prices might swing.
Implied volatility works by measuring price fluctuations against the backdrop of market risk. When the market has bearish leanings, there’s generally an uptick in implied volatility. Conversely, implied volatility decreases when the market turns bullish.
Higher levels of implied volatility can suggest that any price movements occurring may be broader in nature. A stock’s price may shoot up or decline sharply under those conditions. Lower levels of implied volatility typically reduce the likelihood of wide pricing shifts.
How is implied volatility calculated?
So, how is implied volatility calculated? A typical strategy utilizes several key data points that are plugged into an options pricing model. Some of these metrics include:
Option price
Price of the underlying stock or security
Option’s strike price
Expiration date of the options contract
Investors may also incorporate the dividend yield if the underlying stock pays dividends to investors. When an implied volatility calculation is applied, it can tell you how much price movement you can expect to see up until an options contract expires.
How does implied volatility affect options?
Implied volatility can affect options pricing as investors speculate about what might happen with the underlying asset. Whether an option’s price goes up or down can depend on which way implied volatility moves.
When volatility surrounding a security increases, the price of options contracts for that underlying asset tends to rise as well. That means paying a higher premium if you’re purchasing new options contracts for the security.
If volatility is declining, you can end up with lower option prices. Implied volatility may decrease when there’s less demand for the option or market expectations for the option begin to fizzle. Price sensitivity is usually greater with options that have a longer time to expiration or are at-the-money at expiration, meaning their market value is equal to their strike price.
Implied volatility is used to forecast potential movements of stock prices
It’s important to remember with implied volatility, you’re talking about market perceptions. As an investor, you’re trying to understand what may be driving price movements for options contracts and in turn, how much of a profit you might be able to generate from a particular options contract.
Options pricing models
An options pricing model is a mathematical formula that’s used to calculate an option’s value, using a theoretical framework. In applying options pricing models, you’re trying to establish an option’s worth based on a subset of known factors or variables.
With the binomial pricing model, it’s possible to plot out the price of an option at different points in time, up until the expiration date. The binomial model is useful for determining all possibilities for an option’s price movements, then narrowing those possibilities down to the one that appears most likely.
What factors affect implied volatility?
A range of factors influence implied volatility and subsequently, options pricing forecasts. Two of the most significant factors investors should consider are supply and demand and time value.
Supply and demand play a key role in stock pricing. When a stock is in demand, its price tends to rise. On the other hand, a stock’s price may fall if investor interest in it begins to cool. So, what does that mean for implied volatility?
Higher demand can trigger higher levels of implied volatility, followed by higher prices for options contracts. As demand wanes, implied volatility and option premiums follow suit.
An option’s time value reflects how much an investor is willing to pay for that option, above its intrinsic value, prior to its expiration. When an option has a shorter time to expiration, it’s more common to see lower levels of implied volatility. That makes sense, as there’s a smaller window in which price movements may occur.
Options that have a longer time to expiration can have higher levels of implied volatility, as there’s more time for price movements to occur. However, implied volatility is not an absolute predictor of whether the option will end up being in-the-money, out-of-the-money or at-the-money by the time the contract expires.
Historical vs. implied volatility
Implied volatility offers a look at how stock prices might move in the future. Historical volatility, by comparison, is backward-looking.
In technical terms, historical volatility is the annualized standard deviation of past stock price movements. It measures the daily price changes of a stock over the past year.
Essentially, historical volatility and implied volatility are two sides of the same pricing coin. Historical volatility considers what has happened with a stock and what that might mean in the context of future price movements. Implied volatility builds on that by incorporating specific factors into a pricing model to offer a theoretical view of a stock’s future price.
Neither, however, is a guarantee of what a stock will or won’t do.
Why is implied volatility important?
Implied volatility can help shape investors’ thinking about which way a stock’s price may move and how wide or narrow those movements might be. It’s possible to use it to identify potential highs or lows for an underlying security — which can be critical in determining when to make your entry or exit with a particular investment.
Timing can be everything in the market as it can influence how profitable an investment turns out to be. Buy too early and you might overpay. Sell too late and you could rack up losses if your hunch about a stock’s price movements turns out to be wrong.
Implied volatility can help manage risk in options trading. That’s because you can use it as a guide for making investment decisions. But remember: Implied volatility is the equivalent of making a highly educated guess about future price movements. It’s always possible that even with implied volatility calculations on your side, a stock may not act the way that you expect.
Pros and cons of using implied volatility
Implied volatility can help you as an options trader, but there are some drawbacks to consider. You can flesh out your personal options trading strategy by comparing its pros and cons:
Pros
Can offer insight into market sentiment surrounding a security
Can use it to plot entry and exit points
Can help influence options prices
Cons
Doesn't indicate the direction of price movements
Doesn't consider characteristics of a security, beyond price
Can be impacted by geopolitical, social and other current events
Make implied volatility work for you
Implied volatility can be a useful tool in options trading, as it can give you a sense for how volatile the market may be in the future. It can also help you to determine the likelihood of a stock reaching a specific price by a certain time, which can be crucial information when you’re choosing specific options contracts to trade.
If you’re interested in options trading, consider where they fit into your portfolio and choose an option trading platform like Ally Invest that’s both low-cost and user-friendly.
