What is Implied Volatility in Options Contracts?

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The prices of shares keep moving up and down in the market and hence, they are called "volatile" which means not constant over time. Implied volatility means how much the price of an option will move in a given period of time. The term is more applicable in the case of options contracts.

Predicting volatility is a very important issue in finance. Investors often want to know how much an option or a stock can move up or down to reap the benefits and implied volatility can help them ascertain the basics of price movements.

Implied Volatility – Definition

Implies Volatility (or IV) is the measure of the movement of a security in the market within a given time period. In the case of options, the time period is actually the lifetime of the security. That is, the time period of a share option is the life until the expiration of the underlying stock.

As is obvious, IV is just a prediction and not a concrete step. It is calculated depending on various attributes of stocks, i.e., movements in the past, expected rate of return, etc. IV depends on the market data and interprets the movement in order to anticipate the price of a given stock. Therefore, although it is an important tool, there is hardly any evidence that IV is a 100% correct procedure to assume the volatility of the market movements.

Dynamic Nature

Implied Volatility is a dynamic and not a static concept. As the prices of stocks keep going up and down in the market, the implied volatility also keeps changing over time. More often than not, the changes in price are gradual but sometimes, the changes may be rapid taking traders by a surprise.

  • When there is a rapid decline in the market, the IV goes up rapidly.

  • When the market goes up rapidly, IV goes down rapidly as all fears of the bear market disappear.

  • Once the news about price movements is released, the IV is often crushed.

Historical and Implied Volatility

One way to assume the implied volatility of a stock is to check the historical volatility of the stock or option. It is often useful to check the past performance of an option to create or assume its future performance. However, it is not completely true that historical performance will determine the future performance of an option.

Implied Volatility and Individual Investors

Implied volatility is not for rookie investors. One must have enough experience of the market to assume the future price of an option and to gauge in which direction the market will move. It takes enough idea about the market to determine how much price movement will occur in the market, and hence, only experts should take the concept of IV up for calculating market volatility.

Updated on 27-Oct-2021 05:27:26