Implied Volatility - Definition & Equation
What is Implied Volatility?
The term implied volatility refers to an expectation of volatility in the underlying asset from the present till the options expiration, using current options pricing data as a basis. The real benefit of implied volatility is in the fact that it allows us to estimate the size of a move, up or down. The higher the number, the greater the expectation of volatility and price movement in the underlying.
As you can see, the greater the volatility that is presented by an asset, the more expensive an option becomes due to the fact that it has a greater chance of achieving its target. There is also a tendency for implied volatility to increase when the market is bearish and decrease when it is bullish. This occurs due to the fact that the public associates higher levels of risk in a downtrending market versus an uptrending one.
How Do I Calculate Implied Volatility?
The calculation of implied volatility can be derived through the use of a theoretical option pricing model such as Black Scholes Options pricing model. Without going into the nitty gritty details of the Black Scholes formula, you can back into the volatility of an option using this formula if you have the following pieces of data: Current Stock Price, Options expiration date, Risk-Free Rate of return, Exercise price of the option, and dividend yield (if you are calculating IV for a stock). Using these inputs, you may solve for the volatility component of that formula. There are many calculators on the web which will calculate this number for you.