Implied Volatility - Meaning, Impact, Calculation and How to Use It

What is Implied Volatility (IV)?

Implied volatility is the volatility level that makes an option pricing model match the option’s observed market price. It is expressed as an annualised percentage. In simple terms, IV reflects the market’s expectation of how much the underlying asset could move during the remaining life of the option. It does not predict whether the price will rise or fall.

For example, an option with an IV of 20% does not mean that the stock will definitely move 20% during the option’s life. The figure represents that we can assume this as an annualised volatility.

The implied volatility meaning becomes clearer when you compare it with historical volatility. Historical volatility uses previous price data. IV is backed out from the current option price.

What are the Effects of Implied Volatility on Option Pricing?

Implied volatility has a direct relationship with option premiums. When we consider that the other variables remain unchanged, a rise in IV generally increases the theoretical value of both call and put options. On the other hand, a fall in IV generally has the opposite effect. Here is a detailed understanding of how implied volatility affects option pricing:

1. Option Premium

Option premium is influenced by several variables, including the underlying price, strike price, time to expiry, interest rates and volatility. A higher IV usually increases the premium.

For example, just consider two otherwise similar options. One has an IV of 15%, while another has an IV of 25%. The second option will generally carry a higher premium if the other pricing variables remain the same.

2. Influence on Time Value

Implied volatility has a direct effect on the time value of an option. Time value refers to the portion of an option premium. It is linked to the possibility of favourable price movement before expiry. When implied volatility increases, the potential for larger price movements increases. This can raise the option's time value and its premium.

3. Impact on Intrinsic Value

Implied volatility does not directly affect an option's intrinsic value. Intrinsic value depends on the relationship between the underlying asset's current price and the option's strike price. A change in IV can alter the option premium. On the other hand, it does not change the intrinsic value itself.

4. Expectations of Volatility

IV represents expectations about future price fluctuations. It does not tell you the direction of the expected move. Suppose a company is due to announce its quarterly results. The market may expect a larger price movement around the announcement. 

This can push IV higher before the event. After the event, uncertainty may reduce. IV can then fall sharply.

5. Pricing of Out-of-the-Money Options

IV can have a significant effect on out-of-the-money (OTM) options because they have no intrinsic value. Their entire premium consists of time value. When IV increases, the possibility of the underlying asset reaching the strike price before expiry can increase. This can result in a higher premium for OTM options.

6. Options Strategies

An option strategy that has long options can be sensitive to falling IV. On the other hand, a strategy that contains short options can also face risks if volatility rises sharply. The impact depends on the structure of the position, its vega exposure, time to expiry and other variables.

7. Volatility Skew and Smile

IV is not always the same across every strike price or expiry. When IV differs across strikes, the pattern is known as volatility skew. On the other hand, a volatility smile refers to a curved pattern in which options at different strikes have different IV levels. The pattern can reflect differences in demand, supply and perceived risk across contracts.

8. Risk Perception

Implied volatility reflects how the options market perceives future uncertainty. When there is rising uncertainty, IV can increase as the market prices in the possibility of larger price movements. This can also push option premiums higher.

A high IV does not indicate the direction of the underlying asset’s price. It only shows the expected movement and the level of uncertainty is reflected in option prices.
 

What is the Process of Calculating Implied Volatility?

You can calculate implied volatility by using an options pricing model such as the Black-Scholes model. In this model, volatility is the unknown variable. Here is a detailed process of how to calculate implied volatility:

• Select an Options Pricing Model: You need to choose a suitable model, such as the Black-Scholes model. It can help you calculate the theoretical option price.
• Enter the Known Variables: You need to input factors such as the underlying asset price, strike price, time to expiry and risk-free interest rate.
• Use the Market Option Price: After that, take the current market price of the option as the target price for the calculation.
• Solve for Volatility: You can work backwards through the pricing model to find the volatility level that makes the theoretical price match the market price.
• Get the Implied Volatility: Finally, the volatility figure you obtain through this process is the option's implied volatility.

The calculation usually requires numerical methods and repeated iterations because you cannot solve for volatility through a simple formula. However, most trading platforms provide implied volatility as a readily available metric, so users do not usually need to calculate it manually.

How to Use Implied Volatility in Options Trading?

You can use implied volatility as one of several inputs when you analyse options. It can help you explain why two otherwise similar contracts may have different premiums. One common approach is to compare IV across strikes and expiries. Another is to compare current IV with its historical range.

For example, IV may rise before a major corporate event because market participants expect a larger price movement. After the event, IV may fall even if the underlying price moves.

IV can also provide you with context when you evaluate different options strategies. When IV is high, strategies that involve buying options may face higher premiums. On the other hand, when IV is low, option premiums may be lower. But this does not mean that future price movements will remain small.

Disclaimer: It is important to note that you should not view IV as a standalone signal. It does not indicate the direction of an asset’s price. Moreover, it does not guarantee that the actual future volatility will match the implied figure

Difference Between Implied Volatility and Historical Volatility

What is Implied Volatility in Stocks Interpretation?

IV in stocks can vary across strikes and expiry dates. The interpretation depends on the broader option chain. Here is a detailed guide:

1. Low IV in Stocks

Low IV can show you lower expected price movement in the option market. It can result from relatively stable market conditions or lower demand for volatility protection. Low IV is not the same as low risk. Unexpected events can change volatility rapidly.

2. High IV in Stocks

High IV generally means the options market is pricing greater expected price fluctuations. It can occur around events such as earnings announcements, corporate actions or major sector developments. High IV does not show you the stock will rise or fall. Rather, it only reflects a higher expected movement.

3. IV Skew

IV skew refers to the difference in implied volatility across options with different strike prices. It shows how the options market values expected risk at various price levels. For example, the IV of an out-of-the-money option may be different from the IV of an at-the-money option with the same expiry.

What are the Common Mistakes Traders Make?

Understanding implied volatility options requires more than checking whether the IV number is high or low. Here are some mistakes traders make which can lead to an incomplete interpretation:

1. Buying Options the Day Before a High IV Event

IV can rise before an anticipated event. But the event may not produce a large enough price move to offset the premium you pay. IV can also fall after the event. This can reduce the option premium even when the underlying moves.

2. Selling Options When IV Is Low

Low IV can result in relatively lower option premiums. However, a lower premium does not remove the downside risk associated with an option position. A sudden change in market conditions can cause IV to rise quickly. This can affect option premiums even when the underlying asset has not moved significantly.

3. Using Weekly Expiry IV as a Broad Market Indicator

Weekly option IV can change sharply as expiry approaches or around major events. This makes it unsuitable as a standalone measure of overall market sentiment. 

For a broader view of market-level implied volatility, India VIX can provide you with a more appropriate reference. It is designed to measure expected volatility over a wider time horizon.

4. Overlooking Vega Across Multiple Lots

Vega helps you measure sensitivity to a change in implied volatility. For example, a 2% change in IV may appear small when you view it in isolation. On the other hand, across several option contracts, the combined effect can become significant.

These mistakes show why you need to assess IV alongside other factors such as expiry, strike price, option premium and Vega. A single IV figure does not provide you with a complete picture of an options position.

Final Word

Implied volatility is a key component of option pricing. It represents the market-implied expectation of future price fluctuations rather than a prediction of price direction. It can influence option premiums, time value, volatility skew and the sensitivity of options to changes in market expectations.

If you are understanding what is implied volatility, the key point is simple: IV tells you what the options market is pricing for future volatility. It does not guarantee you what will happen next.

IV is easier to understand when you view it alongside other option-chain data. You can use FnO 360 by 5paisa to access different option-chain views, including Price, OI, Straddle and Greeks.