Definition and Examples of Implied Volatility
Implied volatility is a measurement of how much a security will move up or down in a specific time period. With stock options, this period will be the life of the contract (i.e., until the options contract expires).
By its nature as a predictive measure, implied volatility is theoretical. It's based on how the security is behaving in the market and what's happening with supply and demand around that particular stock option. Fundamentally, it's a measure of the market's expectations for how risky that option is.
- Acronym: IV
Implied volatility doesn't predict which direction a particular security will move, only how much it is likely to move in any direction. It gives traders a way to measure potential risk and reward.
How Implied Volatility Works
If a stock has a price of $100 and an implied volatility of 30%, that means its price will most likely stay between $70 and $130 over the course of the next year. That $30 range on either side is known statistically as one standard deviation. It's possible that the stock could stretch two or even three standard deviations (to a range of $10 to $190), but that likelihood decreases with each additional standard deviation.
When you're buying stock options for specific contract periods, however, this yearly IV doesn't tell you exactly what you need to know. To convert this IV to the contract period for a specific option on that stock, you have to take divide that yearly rate into the remaining contract period. You would do this as follows:
- Let's say it's an option with 30 days remaining. There are 12.17 30-day periods in a year.
- Divide the IV by the square root of 12.17 (3.49): 30% / 3.49 = 8.6%.
- That means that the expected movement for this option over the next 30 days is 8.6% of its $100 price, or $8.60. So, it would most likely trade between $91.40 and $108.60 during that time.
Remember, that's only one standard deviation, so the price could still move more than that.
Implied Volatility Is Not Static
There's also the reality that IV can change. In other words, the implied volatility of an option is not constant. It moves higher and lower for a variety of reasons. Most of the time, the changes are gradual. However, there are a few situations in which options change price in quantum leaps—catching rookie traders by surprise.
- When the market declines rapidly, implied volatility tends to increase rapidly. If there is a black swan or similar event (market plunge), IV is likely to surge higher.
- When the market jumps higher, especially after it had been moving lower, all fear of a bear market disappears and an option's premium undergoes a significant and immediate decline.
- Once the news is released (for instance, when earnings are announced or the FDA issues a report), IV is often crushed.
When news is pending for a given stock option (e.g., an earnings announcement or FDA results on a drug trial), buyers are more aggressive than sellers, and that buying demand results in higher implied volatility and therefore higher option premium.
Historical vs. Implied Volatility
One way to understand implied volatility is to contrast it with its opposite type: historical volatility. Unlike IV, historical volatility is a measure of what has actually happened with a security. It measures the average of a security's daily price changes over the past year.
Historical volatility can be a helpful measurement for understanding a stock or option's risk level and even for predicting implied volatility. But historical volatility is not a guarantee of what a particular security will do in the future.
Do not assume that the current market price of any option or spread represents a fair value for your trade plan.
What It Means for Individual Investors
This is not a game for beginners. It requires experience to buy options when the news is pending. You must feel confident in your ability to estimate how the option prices are going to react to the news.
It is not enough to correctly predict the stock price direction when trading options. You must understand how much the option price is likely to change. Only then can you decide whether it is worthwhile to make the play.
- Implied volatility measures how much a security's price is likely to move up or down in a specific period of time.
- Most of the time, changes in implied volatility are gradual, but there are a few situations in which options prices change in big leaps.
- Managing implied volatility is not a game for beginners; it requires experience to buy options when the news is pending.