Implied volatility is a forecast of how much a security's price will move over a specific time period. It's most commonly used to calculate the cost of options contracts.
Examples and Definition
The implied volatility of a security is a measure of how much it will move up or down in a given time period. This time will represent the contract's life in the case of stock options (i.e., until the options contract expires). Implied volatility is a theoretical metric by its very nature as a predictor. It's determined by how the security is performing in the market and what's going on with supply and demand for that specific stock option. Fundamentally, it's a reflection of the market's perception of the riskiness of that choice.IV is an abbreviation for IV.
Implied volatility does not indicate which way a security will move; it just predicts how much it will move in either direction. It allows traders to assess the risk and profit of a trade.What Is Implied Volatility and How Does It Work
If a stock costs $100 and has 30% implied volatility, it will most likely trade between $70 and $130 during the next year. One standard deviation is the difference between the two $30 ranges. The stock might potentially move two or even three standard deviations (to a range of $10 to $190), but the likelihood of this happening lowers with each subsequent standard deviation. When purchasing stock options for specified contract periods, however, this yearly IV does not provide you with all of the information you require. Divide the yearly rate by the remaining contract time to translate this IV to the contract period for a specific option on that stock. This is how you'd go about it: Let's pretend it's a viable alternative with 30 days to go. In a year, there are 12.17 30-day intervals. 30 percent/3.49 = 8.6 percent if the IV is divided by the square root of 12.17 (3.49). That means that during the following 30 days, this option's predicted movement is 8.6 percent of its $100 price, or $8.60. During that time, it would most likely trade between $91.40 and $108.60. Remember, that's just one standard deviation, so the price might fluctuate even more.Implied Volatility Doesn't Stay the Same
There's also the fact that IV is subject to change. In other words, an option's implied volatility is not constant. For a variety of reasons, it rises and falls. The majority of the time, the transformations are gradual. But sometimes, the prices of options change by huge amounts, which can catch new traders off guard. When the market falls sharply, implied volatility tends to rise sharply as well. IV is likely to spike higher if a black swan or equivalent event (market plunge) occurs. When the market rises upward, especially after moving lower, all the anxiety of a bear market vanishes, and the premium on an option drops significantly and quickly. IV is often broken after the news comes out, like when earnings are reported or when the FDA releases a report. When news about a stock option is coming soon, like earnings or FDA results on a drug trial, buyers are more aggressive than sellers. This makes implied volatility go up, which makes the option premium go up.Implied vs. Historical Volatility
One way to grasp implied volatility is to compare it to historical volatility, which is the polar opposite. Historical volatility, unlike IV, is a measure of what has actually occurred with an investment. It calculates the one-year average of a security's daily price fluctuations. Historical volatility can be a useful tool for determining the risk level of a stock or option, as well as anticipating implied volatility. However, previous volatility does not guarantee how an investment will perform in the future. Do not take the current market price of any option or spread as a reasonable value for your trade plan.Individual Investors: What Does It Mean
This is not a game for the faint of heart. Buying options when news is pending demands experience. You must have faith in your ability to predict how the option prices will react to the news. When trading options, it is not enough to precisely estimate the stock price direction. You need to know how much the option price is expected to fluctuate. Only then can you determine whether the play is worthwhile.Important Points to Remember
- The implied volatility of a security refers to how much its price is likely to go up or down over a certain period of time.
- Changes in implied volatility are usually gradual, but there are a few instances where options prices fluctuate dramatically.
- Managing implied volatility is not a beginner's game; buying options when news is pending requires experience.
