What is Implied Volatility?
Implied volatility (IV) is a commonly used technique in the trading world. It means measuring the current price of options contracts that will tell about a theoretical value to the current market price of the option of stocks in question.
Implied volatility definition states that it is a percentage that shows an annual expected standard deviation range for any stock, by looking upon the option prices of that particular stock.
The implied volatility meaning reflects a non-option of financial instrument that boasts embedded optionality. For instance, an interest rate cap can have an IV, too.
Basically, IV is a subjective measure that tells about the magnitude of a stock’s future price changes, as implied by the stock’s price options.
Implied Volatility Explained
Implied volatility lets an investor know about the probability of changes in prices of any security and alert them of the risk rate.
Depending on the demand and supply of options contract and expected share price, it helps an investor to better know about their securities' future price option.
As it helps to find about the anticipated market volatility, IV has a positive relation with expected securities price and one of the parameters used to determine option price.
IV would increase if investors expect a stock’s price to rise in the future and IV falls when an investor expects the stock price to drop in the future.
The implied volatility formula is as follows:
s˜2pT---v.C/S
Here all these symbols represent the following meanings,
- s= Implied volatility
- T= The option contract's duration
- C= Option contract's call price
- S= Contract's strike price
| Stock | 105 Call Price (37 DTE) | 100 Put Price (37 DTE) | Implied Volatility (IV) |
|---|---|---|---|
| PEP ($102) | $0.80 | $1.17 | 16.41% |
| UNP ($103.60) | $2.72 | $1.92 | 30.94% |
For instance, PEP (Pepsi) is trading at $102 and we are looking at options with 37 days to expiration. So the 105 column Pepsi is worth $0.80, while the 100 column Pepsi is worth $1.17. Subsequently, Pepsi’s IV in the 37-day expiration cycle is 16.41%.We look at two different stocks with almost the same options on each of those stocks in the above chart.
Looking at UNP, we have almost a similar price to Pepsi i.e. $103.60 and the 105 call price for 37 days to expiration is $2.72, and for 100 put, it is $1.92.
However, we can see UNP option prices are higher than Pepsi option prices and have an implied volatility of 30.94% in 37 days of an expiration cycle. So it shows that the stock with more expensive options will have higher implied volatility.
There you have the implied volatility example; you now know how to calculate implied volatility, and all in all, what is implied volatility in detail. We hope it helps.
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