Implied Volatility
Implied volatility is a measure used in options trading that reflects the market’s expectations for how much the price of an underlying asset will fluctuate over a given period. Unlike historical volatility, which looks at past price movements, implied volatility is forward-looking and is derived from the current prices of options.
Higher implied volatility suggests the market expects larger price swings, while lower implied volatility suggests the opposite. Importantly, implied volatility does not predict the direction of movement - only the potential magnitude.
Implied volatility is a key input in option pricing models, and it can influence the cost of options:
● Higher implied volatility is generally associated with higher option premiums
● Lower implied volatility is generally associated with lower premiums
Changes in implied volatility can also lead to changes in the price of options.
All else equal, if implied volatility increases, the price of the option may increase; if implied volatility decreases, the price of the option may decrease.
This is because higher implied volatility reflects the market’s expectation of larger future price swings, and traders may therefore be willing to pay more for options.
Why implied volatility matters to investors
Understanding implied volatility can help investors make informed decisions when trading options. It may support:
● Assessing how option prices relate to expected market conditions
● Comparing market expectations against personal views of future price movements
● Recognising how volatility impacts option prices
● Constructing strategies that incorporate views on volatility changes (e.g.spreads, straddles)
However, implied volatility is an estimate not a prediction or guarantee of future price movements.
Options are complex financial products and involve significant risk. They are not suitable for all investors. Understanding their mechanics, pricing influences, and the risk of loss is essential before considering trading.