You have to wade through a lot of jargon when navigating the world of options.

Extrinsic value. Greeks. Moneyness. It can be intimidating. Implied volatility (IV) is a term that is often used but still confusing.

This guide gives the answers you need to understand implied volatility and how it affects options prices.

Before we get into implied volatility, let’s talk about volatility in general. Volatility refers to the price fluctuation of a security.

Volatility is the amount a security's price is expected to move up or down in the future.

Securities with stable prices have low volatility, while securities with large and frequent price moves have high volatility.

What is implied volatility?

Implied volatility is the expected price movement in a security over a period of time. 

Implied volatility is forward-looking and represents the expected volatility in the future. IV estimates the potential price range for a defined time period.

Options traders reference several different types of volatility. Implied volatility, historical volatility, realized volatility, implied volatility rank, and implied volatility percentile are common terms in options trading.

Historical volatility and realized volatility are the same. IV rank defines where current implied volatility is compared to implied volatility over the past year.

For example, a security with implied volatility between 20 and 40 over the past year has a current reading of 30. The security’s IV rank is 50 because implied volatility is at the midpoint of the past year’s range. 

The IV percentile describes the percentage of days in the past year when implied volatility was below the current level. An IV percentile of 60 means that 60% of the time IV was below the current level over the past year.

While there are a lot of terms to consider, you don't need a degree in financial engineering to understand implied volatility. You can listen to podcast 135 to learn more about IV and how to profit from it as an option seller.

What’s the difference between implied volatility and historical volatility?

Implied volatility is forward-looking, while historical volatility is backward-looking. 

Implied volatility is associated with options, while historical volatility is associated with the realized move of the underlying security.

Historical volatility is the realized volatility and describes the past price movement of an underlying security. Historical volatility is presented for a specific timeframe, such as 20 or 30 days or the past year. While past performance is not indicative of future returns, historical volatility gives context to the security’s implied volatility. 

Take the 30-day IV for a security and, a month later, compare it to the realized volatility for the security. What should you expect? The 30-day IV projects future volatility, while the realized volatility lets you compare what happened versus expectations. If IV is significantly higher than realized volatility, options buyers overpaid for the volatility component of the options premium.

The part of an option’s price related to implied volatility tends to be overstated compared to historical volatility. Car insurance companies charge a higher premium than the expected loss on a car insurance policy. Similarly, options implied volatility tends to overstate the realized move on a security.

Yes, prices are sometimes more volatile than expected, but generally, IV is overstated. Listen to “The Expected Probability Paradox” for a deeper dive into implied volatility and expected price moves.

How do you calculate implied volatility?

Implied volatility represents the expected one standard deviation move for a security.

IV is constantly changing with market conditions. For the options trader, implied volatility connects standard deviation, the potential price range of a security, and theoretical pricing models.

IV is traders’ collective expectation of realized volatility in the future for an option contract. Most of the theoretical value inputs for an option’s price are straightforward. Intrinsic value, time until expiration, and interest rates are relatively easy to quantify and can be determined objectively. But, implied volatility is based on assumptions and trader expectations.

Volatility is expressed annually and adjusted based on the terms of an options contract for daily, weekly, monthly, or quarterly expiration. Volatility is proportional to the square root of time. So, daily volatility is approximately 1/16th of annual volatility.

What makes implied volatility go up or down?

Uncertainty increases implied volatility, and stability decreases implied volatility.

IV is forward-looking and represents expected volatility in the future. As IV rises, options prices rise because the expected price range of the underlying security increases. Higher volatility equates to a larger range of potential outcomes.

Implied volatility tends to increase, known as implied volatility expansion, before potentially volatile market events.

Earnings announcements, economic data releases, Federal Reserve announcements, and other events bring uncertainty to the market, increasing volatility. IV decreases after the event (known as implied volatility contraction or “IV crush”) when the uncertainty is removed.

How does volatility affect options pricing?

As implied volatility increases, options prices increase because the expected price range of the underlying security increases.

IV plays a key role in solving for an option’s price. Intrinsic value and extrinsic value combine to determine an option’s price.

Intrinsic value is the value of the option at expiration. The difference between the security's price and the option contract’s strike price is the option’s intrinsic value (or moneyness). For example, a call option with a $50 strike has $5 of intrinsic value if the underlying stock price is $55.

Extrinsic value is the external factors beyond intrinsic value impacting the options price. Extrinsic value includes:

• the time remaining on the contract (theta)
• the volatility of the underlying security (vega)
• the current risk-free interest rate (rho)
• the dividend rate of the underlying security.

The three main factors affecting an option's price are intrinsic value, time until expiration, and volatility of the underlying security.

The options Greek vega measures the effect of changes in IV on an option’s price. Vega is the amount an options price changes for every 1% change in IV in the underlying security. 

You cannot predict future volatility. Therefore, vega represents an unknown element in options pricing because it’s not based on past price moves. As volatility increases, an option’s price increases as market participants anticipate a large price move may be possible before expiration. Vega decreases as expiration approaches because there is less time for volatile price swings to occur. 

Conclusion

Options traders are interested in the market’s direction (price) and speed (volatility). Implied volatility reflects traders’ expectations for the speed of the market’s movements. Value and price diverge when trader’s expectations differ. 

It is up to the options trader to determine when market conditions favor selling overpriced volatility and buying underpriced volatility. Our free Pricing and Volatility course is the next step to better understand this topic and improve your options trading.