What is 'implied volatility'?
Options quotes include this term, which appears to be in percent. I have been unable to find how it is arrived at or what it means.
Best Answer
244 points
KenLong answered 2 years ago …
It is volitility that is implied by the market makers. As compared to historical volitility that can be calculated by the stocks price action.
In addition to the measurable variables, stock price, strike price, time, interest rate, and volitility. There is also the implied volitility. This is the option markets way of pricing in demand.
In stock trading there is a fixed supply, outstanding shares, created when a company issues stock. These shares are then held by large brokerage houses who make them available to the public at an offered price.
In option trading there is no such supply. Option contracts are created to satisfy demand. If traders are demanding contracts, somebody has to supply them. In order to compensate themselves for their effort options market makers run a spread, the difference between the bid and ask price, which is their profit. In order to compensate themselves for taking on unknown risk they use implied volitility to adjust the options price.
If demand for an option goes up, the price goes up. Regardless of its accual value based on measurable variables. This is the role of implied volitility, and is why the theoretical value based on a computation is often different from the accual value.
Have you ever seen a newsletter writer recomend an option on an illiquid stock, and seen the options price double while the stocks price remains unchanged? This is implied volitility.
Every option contract has two sides, buyer and seller. If there is a glut of buyers, somebody still has to create and supply the contracts, the market maker. He does not want to get stuck holding the risky contracts, hes just the middle man, so he pushes up the price. He needs to entice the traders to take the risk of selling the options.
Answers
2183 points
ChaosNantuko answered 2 years ago …
the calculation is complicated, and i don't remember exactly what the calcuation is. I can tell you what its for though. First, i'll tell you what volatility is being spoken of. The volatility is a measure of how much the stock is expected to move. Higher amounts of volatility indicate the stock will move a lot, while lower amounts of volatility indicate the stock won't move a lot. Historical volatility is a measure of how volatile the stock has been in the past. Implied volatility is the amount of volatility that is priced into the option at that point in time. If implied volatility is higher the historical volatility, the option could be considered overpriced, while if its less then historical volatility, the option could be considered under priced. That isn't the complete picture though, because events can cause an increase in short term volatility, and so the historical volatility can't always be counted on to be accurate for shorter time spans.
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