Implied Volatility
Implied volatility is an option-specific term. Implied volatility is the market’s measure of the future volatility of an underlying asset. If that sounds complicated, let me break it down for you…
There are four major factors affecting an options price. These factors are volatility, time decay, probability, and interest. Dividends can also come into play, but we’re talking about volatility… so let’s stay on topic.
In options trading, volatility is measured and most often used as historical volatility and implied volatility. Historical volatility of an asset, or stock, is exactly as it sounds… a historical measure of an asset’s volatility.
For example, if you look at historical volatility from December 2010 for US Steel (X), it’s 21.59. It’s probably a bit more volatile than the average stock. Meaning, the stock price moved around, but not in mad, wild swings.
Now, take AgFeed Industries (FEED) for example. Their historical volatility from December 2010 is very high at 48.98. That means FEED moved in big swings and big chunks in December 2010.
While historical volatility measures the previous volatility of an asset or stock in this case… implied volatility is the market’s estimate of the underlying asset’s possible magnitude of move in either direction.
Often, the implied volatility of an option is used as a measure of the option’s relative value, rather than its price. The reason being, the price of an option depends most directly on the price of its underlying asset.
We’re just scratching the surface of how in depth we can get on the topic of implied volatility. With that said, we’d be remiss if we didn’t at least mention the role of options pricing models.
I’m sure you’d agree, it’s important to know the working parts in an asset you are trading. The average trader should simply know this, even if you don’t actively use it.
Bottom line…
The higher the implied volatility, the more an asset is expected to move. Therefore, there’s a greater possibility that the underlying asset will move in your favor.
Just the opposite is true with low implied volatility. The lower the implied volatility, the more stagnant the asset is expected to be. As such, it lowers the possibility that the stock will move in your favor.
Category: Options Trading Basics
