Implied volatility (IV) is a fundamental concept used in options pricing. Essentially, it is a metric that reflects the market’s view on the likelihood of changes in a security’s price. It is often used to price options contracts, and it’s derived from an option’s premium.
Here’s how it works: options pricing models typically use variables like the price of the underlying asset, the option’s strike price, the time until the option expires, and a risk-free interest rate. However, these models also need an expected volatility input. This volatility is the implied volatility and is backed out from the market price of the option.
This implied volatility isn’t a direct forecast of future price volatility. Instead, it’s a reflection of what the market thinks future volatility could be. So, higher implied volatility generally means that larger price swings are expected, and such options will be pricier due to the increased risk for the option holder. Conversely, lower implied volatility indicates a lesser expected price movement.
Keep in mind, implied volatility does not have directional bias. It doesn’t predict the direction of the price movement, just the degree.