Glossary
Implied volatility
The future volatility the market is pricing into an option, backed out from its premium with a pricing model.
Implied volatility (IV) is the level of future price fluctuation that makes an option pricing model, usually Black-Scholes or a variant, reproduce the option's current market price. It is quoted as an annualized percentage. Since every other input to the model (stock price, strike, time, interest rate, dividends) is observable, IV is the one number that captures how much movement the market is paying for. Higher IV means more expensive options, all else equal.
How it works
Traders do not calculate IV from a formula directly; they solve the model backward, searching for the volatility that matches the premium. A handy approximation converts it into an expected range:
What moves it
- Scheduled events. IV usually rises before earnings, drug trial results or court rulings, then collapses once the news is out, the "IV crush" that can sink option buyers even when they get the direction right.
- Market stress. Index IV spikes in sell-offs; the VIX is a measure of 30-day implied volatility on S&P 500 options.
- Supply and demand for particular strikes. Downside puts on indexes normally carry higher IV than calls, a pattern called skew.
Implied versus realized
IV is a forecast embedded in prices; historical or realized volatility is what actually happened. Options sellers profit, on average, when IV exceeds subsequent realized volatility, which it often does, but the exceptions can be severe. An option's sensitivity to IV changes is its vega.