What is Implied Volatility?

Implied volatility is an estimate of the price volatility of a security, based on available data. Typically implied volatility measurements are not as accurate as the actual volatility, but in situations where people want to predict how a security will move, estimating implied volatility is better than going into a deal without any information at all. Financial publications may publish implied volatility numbers for commonly traded securities and it is also possible to calculate this number. There are a number of implied volatility calculators available online.

Volatility itself is a price movement. The higher the volatility, the more likely a security is to experience radical swings in value. Past performance is usually a strong indicator of future volatility, but it is not the only influence on a security's volatility. When people calculate implied volatility, they do so from within the context of an options contract.

First they look at the market price for the underlying security, as well as the strike price written into the options contract. They also examine the expiration date on the contract, and the value of the options contract itself. There are several different formulas which can be used to find implied volatility, and other factors such as interest rates may also be incorporated, depending on the security involved.

If the volatility is high, it means that the options contract is probably more likely to be exercised, unless the value moves in the wrong direction. Someone who buys a call option is counting on values to rise so that he or she can buy at the lower strike price, while someone holding a put option hopes that values will fall so that she or he can sell at the higher strike price. As the value of an option goes up, it suggests an increase in volatility, as the people who are buying and selling options are positioning themselves carefully to avoid taking a loss.

Bull markets tend to decrease implied volatility. In a bear market, implied volatility measurements are generally high because people perceive the market as less stable and expect to see prices varying widely. However, like all predictions related to the markets, it is possible for implied volatility to be wrong. Even the most careful calculations cannot account for factors which are unexpected, and these factors can radically skew securities values very quickly, leaving even experienced investors floundering to avoid or minimize their losses.