Volatility is one of the six inputs of an option-pricing model. Some of the other inputs - strike price, stock price, the number of days until expiration, and the current interest rate - are easily observable.
Some traders mistakenly believe that volatility is based on a directional trend in the stock price. Not so, by definition, volatility is simply the amount the stock price fluctuates, without regard for direction.
As an individual trader, you really only need to concern yourself with two forms of volatility: historical volatility and implied volatility. Historical volatility is defined in textbooks as "the annualized standard deviation of past stock price movements." But here, let's just say it's how much the stock price fluctuated on a day-to-day basis over a one-year period.
Implied volatility isn't based on historical pricing data on the stock. Instead, it's what the marketplace is "implying" the volatility of the stock will be in the future, based on the price changes in an option. Like historical volatility, this figure is expressed on an annualized basis. But implied volatility is typical of more interest to retail options traders than historical volatility because it's forward-looking.
For a specific stock price
Implied volatility is a dynamic figure that changes based on activity in the options marketplace. Usually, when implied volatility increases, the price of options will increase as well, assuming all other things remain constant. So when implied volatility increases after a trade has been placed, it's good for the option owner and bad for the option seller.
Conversely, if implied volatility decreases after your trade is placed, the price of options usually decreases. That's good if you're an option seller and bad if you're an option owner.
Given implied volatility will yield a unique option value. Take a stock trading at $44.22 that has the 60-day $45-strike call at a theoretical value of $1.10 with an 18% implied volatility level. If the stock price remains constant, but IV raises to 19%, the value of the call will rise by its vega (in this case let's say about 0.07). The new value of the call will be $1.17 ($1.10+0.07). Rising IV another point to 20%, raises the theoretical value by another 0.07, to $1.24.
The question is: Where does implied volatility come from?
Based on truth and rumors in the marketplace, option prices will begin to change. If there's an earnings announcement or a major court decision coming up, traders will alter trading patterns on certain options. That drives the price of those options up or down, independent of stock price movement. Keep in mind, it's not the options' intrinsic value(if any) that is changing. Only the options' time value is affected.
The reason the option' time value will change is because of changes in the perceived potential range of future price movement on the stock. Implied volatility can then be derived from the cost of the option. In fact, if there were no options traded on a given stock, there would be no way to calculate implied volatility.
