Implied volatility (commonly referred to as volatility or IV) is one of the most important metrics to understand and be aware of when trading options.
In simple terms, IV is determined by the current price of option contracts on a particular stock or future. It is represented as a percentage that indicates the annualized expected one standard deviation range for the stock based on the option prices.
For example, an IV of 25% on a $200 stock would represent a one standard deviation range of $50 over the next year.
In statistics, one standard deviation is a measurement that encompasses approximately 68.2% of outcomes.
When it comes to IV, one standard deviation means that there is approximately a 68% probability of a stock settling within the expected range as determined by option prices. In the example of a $200 stock with an IV of 25%, it would mean that there is an implied 68% probability that the stock is between $150 and $250 in one year.
Options are insurance contracts, and when the future of an asset becomes more uncertain, there is more demand for insurance on that asset.
When applied to stocks, this means that a stock’s options will become more expensive as market participants become more uncertain about that stock’s performance in the future.
When the uncertainty related to a stock increases and the option prices are traded to higher prices, IV will increase. This is sometimes referred to as an “IV expansion.”
On the opposite side of IV expansion is “IV contraction.” This occurs when the fear and uncertainty related to a stock diminishes.
Why You Should Use Implied Volatility to Buy and Sell Options
As this happens, the stock’s options decrease in price which results in a decrease in IV.
In summary, IV is a standardized way to measure the prices of options from stock to stock without having to analyze the actual prices of the options.