Implied volatility: why it matters and how it works

Implied volatility is a measure of the expected volatility of an underlying asset, and it is an important metric when pricing options strategies. The calculation of implied volatility is based on the market price of an option and the inputs used in the option pricing model.

Pricing options premium

The most commonly used option pricing model is the Black-Scholes model. The Black-Scholes model takes into account the current stock price, the strike price of the option, the time to expiration, the risk-free interest rate, and the volatility of the underlying asset. The volatility input is the implied volatility, which is the only input that cannot be directly observed in the market.

To calculate implied volatility, the option pricing model is used to calculate the theoretical price of an option, and the calculated price is then compared to the market price. If the calculated price is different from the market price, the model inputs are adjusted until the calculated price matches the market price. The volatility input that results in a match between the calculated and market price is the implied volatility.

How it works

One way to understand implied volatility is to think of it as the market's expectation of how volatile the underlying asset will be in the future. A high implied volatility means that the market expects the asset to be more volatile, and a low implied volatility means that the market expects the asset to be less volatile.

Implied volatility is important when pricing options strategies because it is used to determine the theoretical value of an option. An option with a high implied volatility will have a higher theoretical value than an option with a low implied volatility. This is because a high implied volatility means that the market expects the underlying asset to be more volatile, which increases the probability of the option being in-the-money at expiration.

In addition, implied volatility is also used to determine the risk of an options strategy. A strategy with a high implied volatility will have a higher risk than a strategy with a low implied volatility.

In conclusion

Implied volatility is a measure of the expected volatility of an underlying asset and it is an important metric when pricing options strategies. The calculation of implied volatility is based on the market price of an option and the inputs used in the option pricing model. Understanding implied volatility allows investors to make more informed decisions about the risk and potential return of an options strategy.