What it means
Options are contracts that give the right to buy or sell an asset at a set price. Their prices depend on several things, including the current price, the set price, the time left and the likely size of future price moves.
Of these, the expected movement is the only one that cannot be observed directly, so it is worked out backwards from the option's market price. That backward calculation is implied volatility.
Analysts take an option pricing model, enter all the known inputs and then solve for the volatility figure that makes the model price equal the market price. The result is usually quoted as an annual percentage.
A higher implied volatility makes options more expensive, because large moves make it more likely that an option ends up valuable. Implied volatility tends to rise around events such as earnings announcements or elections and often jumps when markets fall.
A well-known index of expected volatility on the US stock market, the VIX, is built from options prices in this way. Implied volatility differs from historical volatility, which measures how much prices actually moved in the past.
The implied figure is forward-looking and reflects what traders expect and what they are willing to pay for protection. When the two diverge, traders ask whether options are cheap or expensive relative to the risk.
For a non-finance professional, the figure is a quick measure of market fear or calm. A company granting share options to staff, or hedging currency risk with options, will find that implied volatility drives the cost.
It is not a forecast of direction, only of the size of expected moves. Use caution with the number.
It depends on the model chosen and on the supply and demand for options at the time, so it is an estimate and not a fact. Different options on the same asset can also show different implied volatilities.
In practice
Real-world examples.
Example
A technology company is about to report earnings, and the implied volatility of its options jumps. The finance team sees that the market expects a large move in either direction. The investor relations lead prepares for questions from both optimistic and nervous shareholders.
Example
A treasurer who wants to protect against a fall in the dollar price of a foreign currency compares option quotes from two banks. The bank with the lower implied volatility is offering the cheaper protection. She checks that the contract terms are otherwise identical.
Example
A start-up grants share options to employees and its auditors need a fair value for them. The valuation uses a volatility figure based on the implied volatility of similar listed companies. The finance manager documents the source of the inputs.
Formula
Calculation
Expected one-standard-deviation move = share price x implied volatility x square root of time in years
Suppose a share trades at $100 and its options imply a volatility of 30% a year. For a period of three months, time is 0.25 years and its square root is 0.5. Expected move = 100 x 0.30 x 0.5 = $15. The market is therefore pricing roughly a two-in-three chance that the share ends the three months between $85 and $115.Case study
Seen in the real world.
Brightwave Foods is an illustrative, fictional company that imports coffee and prices contracts in dollars. The finance director wanted to protect against a sharp move in a key currency and was quoted a premium for options that seemed high.
She asked the bank to explain the price and learned that the implied volatility of the currency had risen because of an upcoming election. She compared it with the historical volatility, which was lower, and concluded that protection was expensive for the moment.
The company bought a smaller amount of protection now and planned to buy more after the election, when implied volatility was expected to fall. The illustrative lesson is that the cost of hedging with options moves with market nerves, so timing and amount both matter.
Watch out
Common mistakes.
- Treating implied volatility as a forecast of the direction of the price, when it only measures the expected size of moves.
- Confusing implied volatility with historical volatility, when one looks forward and the other measures what already happened.
- Assuming the figure is exact, when it depends on the model used and on supply and demand for options.
Questions
People also ask.
Why does implied volatility rise before earnings?
Because the market expects a bigger move once the result is known, so options become more expensive.
Does a high implied volatility mean the price will fall?
No, it means a large move is expected in either direction.
What else can IV mean?
Intrinsic value or the Roman numeral four, so the context decides which is intended.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%