What Is Implied Volatility (IV)?
Implied volatility determines the likelihood of fluctuation in a given security's price. It helps investors to predict future moves and supply and demand and implement these predictions to price options contracts. Implied volatility is different from historical volatility, which determines the market fluctuations and their outcomes in the past.
Working of Implied Volatility (IV)
Implied volatility is the market's prediction of price movement. Investors use it to determine future fluctuations in the price of the security. It is considered a proxy of market risk and is denoted by σ (sigma). Standard deviations and percentages are the most common way to express it over a specified time horizon.
In the stock market, implied volatility is higher for bearish markets and falls in a bullish market. Most equity investors consider a bearish market riskier and undesirable.
A limitation of implied volatility (IV) is that it doesn't forecast the direction of price fluctuation. For instance, high volatility indicates a large price swing, either downward or upward.
Low volatility indicates that significant, unexpected changes in price are potentially unlikely.
Factors Affecting Implied Volatility
Implied volatility is liable to unpredictable changes. The factors that affect implied volatility the most are supply and demand. The price typically increases when there is a great demand for an asset. And so does the implied volatility, which raises the option premium because the option is riskier.
Likewise, an increase in supply, even when the stock isn't in demand, decreases implied volatility, leading to a reduced option price.
The time value of the option, or the duration until expiration, is another variable that affects premiums. While long-dated options typically have high implied volatility, short-dated options frequently have low implied volatility. The distinction is in the time left in expiration. The price has more time to move into a more advantageous price level than the strike price since there is more time.
Implied Volatility: Pros and Cons
Market sentiment can be measured with the use of implied volatility. It estimates the potential size of a movement for an asset. However, it does not show the movement's direction. Option writers will employ computations to price options contracts, including implied volatility. In addition, many investors consider the implied volatility (IV) when making an investment decision.
Implied volatility is entirely dependent on pricing instead of underlying market assets. Additionally, negative news and events like wars or natural catastrophes could affect implied volatility.
Pros
1. Helps set options prices
2. Estimates market sentiment, uncertainty
3. Discover trading strategy
Cons
1. Sole dependence on prices
2. Susceptible to unexpected news events and factors
3. It helps only in movement prediction
What Impact Do Variations in Implied Volatility Have on Option Prices?
The price of an option, or premium, will rise if implied volatility increases, whether the option is a call or a put. It occurs because the value of an option is determined by the possibility that it would expire in the money (ITM). Since volatility quantifies how much a price changes, higher volatility indicates significant movements in future prices. Ultimately, there are more chances for the option to finish ITM.