Implied Volatility in Options Trading explained
Implied Volatility (IV), also known as projected volatility, is used in option trading. It is the forecast of the underlying asset’s volatility as implied by the option prices in the market.
It is denoted by the sigma symbol (σ) and expressed in percentages, e.g., σ = 20%.
The implied volatility is the answer to the question “What volatility do I need to plug into the Black-Scholes(-Merton) option pricing model in order to arrive at the current price of the option?”
Each particular option contract (call, put, strike price, expiration date) has its own implied volatility, it is the market’s forecast of a likely movement in price. This difference in implied volatility levels for options with the same underlying security is known as volatility skew.
The higher the implied volatility, the higher the time value of the option.
- When option prices inflate, the implied volatility increases, and probabilities widen.
- When option prices deflate, the implied volatility decreases, and probabilities narrow.