Implied volatility
Family III · Risk
Not to be confused with volatility.
Implied volatility is a forward-looking estimate of price variability extracted from option prices rather than measured from past returns. It is the single input in a pricing model that is solved for, given all other inputs and the traded premium. Because it reflects the market's current consensus, it changes as supply and demand for options change.
How it is obtained
An option pricing model such as Black-Scholes takes five inputs: underlying price, strike, time to expiry, interest rate and volatility. Four are observable or contractually fixed. The fifth, volatility, is backed out by finding the value that reproduces the market premium. That value is the implied volatility.
Implied volatility is quoted as an annualised percentage. It is not a forecast of direction; it describes the dispersion of returns the option market is pricing. Different strikes and expiries on the same underlying typically produce different implied volatilities, a pattern known as the volatility smile or skew.
Worked example
A call option on a stock trading at 100 has a strike of 100 and 30 days to expiry. The risk-free rate is 4% and the market premium is 2.50. Solving the model for volatility gives:
The 28.5% is annualised. Over 30 days the one-standard-deviation move is roughly 28.5% × √(30/365) ≈ 8.2%, or about 8.20 in price terms.
Use and interpretation
Implied volatility is used to compare option prices across strikes, expiries and underlyings on a normalised basis. A rise in implied volatility generally increases the premium of both calls and puts, all else equal. Traders often distinguish between implied and subsequent realised volatility, since the former is a market price and the latter is an outcome.
Levels vary widely by asset class, market conditions and expiry. There is no universal normal level; what is high for one underlying may be low for another. Implied volatility also tends to rise before scheduled events such as earnings or central bank decisions and fall afterwards.
Often confused with
- volatility
- Volatility is the general statistical property of an asset's returns, often measured from historical data, whereas implied volatility is a specific number backed out of option prices; the visible sign is that implied volatility is quoted as a percentage derived from a premium, while volatility can be calculated from any return series without reference to options.