InvestorQ : What is implied volatility and how is it calculated
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What is implied volatility and how is it calculated

Rashi Mehra answered.
3 years ago

When we calculate the price of the option using the Black and Scholes method, one of the key factors is volatility of the stock. There we assume that the volatility of the stock is unknown. There is another way to approach volatility. You take the market price of the option of a particular strike as the fair value and then take the volatility as the unknown. The volatility thus calculated is called implied volatility. It is one of the most important measures in options pricing. Implied volatility represents the expected volatility of a stock over the life of the option which could either be 1 month, 2 months or 3 months in the Indian context. More practically, it is the time to expiry of the option. As expectations change, option premiums react appropriately. Implied volatility is influenced by the supply and demand of the underlying options and by the market's expectation of the share price's direction. As expectations rise of the price moving either ways, or as the demand for the option increases, implied volatility will rise. Options that have high levels of implied volatility will result in high-priced option premiums. Normally, IV is a buy low and sell high kind of an approach. You normally buy options with low IVs with the expectation that the IV will move up. Alternatively you can sell options with high IVs in the hope that the IV will come down. Here you bet on the movements in volatility and not so much on the price per se.

Conversely, as the market's expectations decrease, or demand for an option diminishes, implied volatility will decrease. Options containing lower levels of implied volatility will result in cheaper option prices. This is important because the rise and fall of implied volatility will determine how expensive or cheap time value is to the option, which can, in turn, affect the success of an options trade.

For example, if you own options when implied volatility increases, the price of these options climbs higher. Which is we say that buying low makes sense. A change in implied volatility for the worse can create losses, however – even when you are right about the stock's direction. That means if the stock that you own goes up by 5% but the IV crash then the option price can still go down sharply resulting in losses for you. That is why IV is relevant. Each listed option has a unique sensitivity to implied volatility changes. For example, short-dated options will be less sensitive to implied volatility, while long-dated options will be more sensitive. This exactly like how short term debt is less vulnerable to changes in yields but long dated debt is more vulnerable to changes in interest yields. This is based on the fact that long-dated options have more time value priced into them, while short-dated options have less of time value. After all, IVs impact the time value and not the intrinsic value of an option.

Another interpretation of IV is that each strike price will also respond differently to implied volatility changes. Options with strike prices that are near the money are most sensitive to implied volatility changes, while options that are further in the money or deep out of the money, OTM calls and puts, will be less sensitive to implied volatility changes. An option's sensitivity to implied volatility changes can be determined by Vega – an option Greek. What you need to remember is that as the stock's price fluctuates and as the time until expiration passes, the Vega values increase or it can also decrease depending on these changes. This means an option can become more or less sensitive to implied volatility changes. In any Vega chart we can see such shifts quite clearly.