What is implied volatility? At its most simple, implied volatility is essentially a measure of the market’s forecast of the likelihood of movement in the price of a particular security. It is often used by investors and market watchers to estimate potential fluctuations in the price of a security, asset or instrument.
This metric is of interest to market analysts and investors as volatility tends to increase in ‘bearish’ markets, while also decreasing when the market sentiment is ‘bullish’. In this sense, measuring volatility in this way can be used to make predictions about the general direction of a particular market in the future.
With this basic understanding in mind, in this short article we will do a deep dive on what exactly ‘implied volatility’ is, why it matters, and how you can use it in your trading strategies. While implied volatility might be one of the more technical concepts to wrap your head around, once you have a basic understanding of what it is, it will prove useful when the time comes to tweak your trading strategy.
What is Volatility?
Before we set out what implied volatility is and how it works, we should first set out an understanding of what ‘volatility’ is in more general terms.
Volatility is a measure of the swings in prices of a particular asset or financial instrument. It will usually be measured in relation to the mean price and will act as a statistical measure of the fluctuations above or below this mark. Volatility can be measured in a number of different ways, with implied volatility being one of these.
Generally speaking, an asset that is highly volatile will be considered more risky than an asset with less volatility. This is because the price is so unpredictable. However, some traders also use volatility to their advantage, as it can present trading opportunities.
In this sense, ‘volatility’ can also be thought of as a measure of risk, given that it also represents the possibility that the price of a security, asset or instrument will fluctuate downwards or upwards. Low volatility is lower risk as it suggests that the average price is fairly stable. On the other hand, high volatility is associated with higher risk levels as the potential for deviation is higher.
How Does Implied Volatility Work?
Now that we have a sense of what is implied volatility, we can now look more closely at exactly how it works.
As we have seen, implied volatility is the market’s forecast or prediction of the potential price movements in the price of a particular security, asset or financial instrument. Investors and market analysts will use it to generate a rough prediction of future price fluctuations.
When this metric is applied to a market – such as the stock market – implied volatility will tend to increase when the overall direction of the market is bearish in nature. Bearish markets happen when investors believe that prices will decline over time. Conversely, implied volatility will also decrease when the market sentiment is more positive. As bearish markets involve the risk of price decreases, investors and traders tend to want to avoid risk and protect themselves from any losses.
However, it should be noted that implied volatility doesn’t necessarily predict specific price directions upwards or downwards. Rather, it measures the overall unpredictability of these movements and whether we might see very large swings up and down.
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Implied Volatility and Options
We mainly tend to see implied volatility used in the context of pricing options. But what are options?
Options are essentially financial derivatives that give those buying them the right – though not necessarily the obligation – to buy or sell an asset at an agreed price and date.
Options are a popular instrument as they can be used to allow a trader to hold a leveraged position in a particular asset at a cost that is lower than owning it outright. In this way, they can also be used by traders to hedge or reduce the risk exposure of their portfolio.
Measuring implied volatility can be used to approximate what an option will be worth in the future. This is important as options that have a higher implied volatility will have higher premiums attached to them, while the opposite will be true of those with lower implied volatility.
How is Implied Volatility Calculated?
How is implied volatility calculated? Option pricing models are often used to determine implied volatility. The two main models used to do this are the Black-Scholes model and the Binomial model.
The Black-Scholes model considers and factors in the current stock price, the options strike price, the time until the expiration of the option contract, and risk-free interest rates.
The Binomial model will use a tree diagram and will factor in volatility at each level to show the possible pricing paths that an option can take. It will then work backwards to determine one price.
Implied Volatility vs Historical Volatility
One common mistake that people make about implied volatility is confusing it with historical volatility. While there are some similarities between the two concepts, they are different in important regards.
Also known as ‘realised volatility’ or ‘statistical volatility’, historical volatility measures the ranges of returns for a particular security, asset or market index over a set period of time. It is ‘historical’ as it is backward looking and only concerned with specific periods of time in the past. Generally speaking, the higher the historical volatility of an asset, the riskier it will be.
As we can see, while historical volatility is primarily concerned with past volatility, implied volatility focuses more on present market sentiment. For this reason, historical volatility tends to be a less frequently used metric as generally traders and analysts want to make predictions about future pricing.
What Impacts Implied Volatility?
There are a number of factors that might influence the implied volatility of a particular asset or instrument. Most immediately, supply and demand will be a major determining factor as when an asset or instrument is in higher demand, the price will rise. When this occurs, the implied volatility will also rise.
As a result, the option in question might have a higher premium attached to it given that it is now more risky. In much the same way, if there is too much supply and inadequate demand in the market, the implied volatility will fall and it will become cheaper.
Another factor impacting implied volatility is the time value attached to the option in question. As we know, options contracts are often time sensitive as they set out a date and time when the buyer can take someone up on the agreement to buy or sell.
An option that is short-dated or has less time until it expires will often have less implied volatility. In contrast, an option with a much longer time until it expires will typically have more implied volatility. The reason for this variation is because with a longer period until expiration, the price has more time to move in a favourable direction towards the strike price.
Conclusion
To sum up, implied volatility is a way of capturing the market’s view that a particular asset, security or instrument will undergo price changes. It is often used in the context of pricing options contracts, with higher implied volatility often resulting in options contracts having a higher premium attached to them.
As a way of quantifying the market sentiment, when it is calculated, it is based solely on prices. It will also be impacted by the supply and demand levels of a particular asset, as well as the time value attached to an option contract. Implied volatility typically increases when the market sentiment is bearish and decreases when it is bullish.
Despite this, however, there are some limitations to an implied volatility chart worth considering. In particular, it has been criticised as it is overly reliant on prices rather than fundamentals. It also tends to be sensitive to unexpected factors such as political news or other market developments, and in this way it might present skewed data. Furthermore, it also primarily predicts price movements in general, rather than specific directions.
Nevertheless, despite the limitations in how implied volatility is calculated, it is frequently used by traders as it is a decent way to get a rough sense of the market sentiment and can represent that in a quantifiable figure. It is also useful in the setting of options pricing and can be used to shape trading strategy.
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