Implied volatility is a measure of the expected price fluctuation of an asset, such as a stock or an option, over a specific period. It is derived from the market price of an option and reflects the market's expectations of how volatile the asset's price will be in the future.
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Implied volatility indicates how much uncertainty or risk is priced into an asset’s future price movements.
Implied volatility is often used by traders to gauge market sentiment and the level of risk they are taking on when trading options. It is not based on past price movements, like historical volatility, but rather on the expectations of future volatility. When implied volatility is high, it suggests that investors expect large price movements, which can lead to higher option premiums.
Conversely, when implied volatility is low, the market expects smaller price changes, leading to lower premiums. Implied volatility can change quickly in response to market events, such as earnings reports, geopolitical events, or economic data releases.
Short example:
Suppose an investor buys a call option for a stock with an implied volatility of 30%.
This means the market expects the stock to move significantly, up or down, by 30% annualized over the life of the option.
If the implied volatility rises to 40%, the option's price may increase due to the market's expectation of larger price fluctuations in the stock.
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