# How Implied Volatility (IV) Works With Options and Examples

![Graphic illustrating implied volatility with formula depiction and relevance description.](https://www.investopedia.com/thmb/v88nFBThHANJPkNHw0F5GMoAUko=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Term-Definitions_IV-3e90aaab2e7a42b4a50211aaa927c078.jpg)

*— Investopedia / Jessica Olah*

> **Definition**
>
> Implied volatility reflects investors' perceptions of uncertainty or risk associated with the future movements of an asset.

## What Is Implied Volatility (IV)?

Implied volatility (IV) measures how much the market believes the price of a stock or other underlying asset will move in the future. Investors can often find implied volatility data through a leading [options trading platform](https://www.investopedia.com/the-best-brokers-for-options-trading-8763492). This data can be used to project future moves and supply and demand, and is often employed to price options contracts. Implied volatility isn't the same as [historical volatility](https://www.investopedia.com/terms/h/historicalvolatility.asp), also known as realized volatility or statistical volatility. Historical volatility measures past market changes and their actual results.

### Key Takeaways

*   Implied volatility is often used to price option contracts when high implied volatility results in options with higher premiums and vice versa.
*   Supply and demand and time value are major determining factors for calculating implied volatility.
*   Implied volatility usually increases in bearish markets and decreases when the market is bullish.
*   IV helps quantify market sentiment and uncertainty, but it's based solely on prices rather than fundamentals.
*   Implied volatility data can be found through a leading [options trading platform](https://www.investopedia.com/the-best-brokers-for-options-trading-8763492), typically on the options chain.

## How Implied Volatility (IV) Works

Implied volatility is a key factor in determining the price of an [options contract](https://www.investopedia.com/terms/o/optionscontract.asp). Traders aren't just gaining exposure to the direction of the stock price when they buy or sell options, but also to how much the price might fluctuate in either direction before the option expires.

Historical volatility measures past price fluctuations observed in the data, but implied volatility is forward-looking. It's derived from the current market price. As a result, it isn't directly observable in the market. Instead, it must be calculated using an options pricing model like [Black-Scholes](https://www.investopedia.com/terms/b/blackscholes.asp). You would start with the current price of the option and work backward to determine the level of volatility that would justify that price, given all the other known variables entered into the model.

Implied volatility is often used as a heuristic gauge of market sentiment, particularly fear and uncertainty. It tends to be low when markets are calm and traders are complacent, but it can spike higher when there's a lot of uncertainty or concern about potential risks.

One well-known example is the "VIX" or the [CBOE Volatility Index,](https://www.investopedia.com/terms/v/vix.asp) which is a measure of the implied volatility of S&P 500 index options. The VIX is sometimes referred to as the stock market's "fear gauge" because it tends to spike higher during times of market stress or uncertainty. Traders watch indicators like the VIX closely because spikes in implied volatility can often precede significant market moves.

> **Important**
>
> Implied volatility isn't dependent on the direction of the stock price movement but rather on the magnitude of the movement. It doesn't indicate whether the price of the underlying asset is expected to go up or down. It measures how much the market believes the price could change in either direction.

## How Traders Use Implied Volatility

Traders use implied volatility in a few ways. It helps them gauge whether option prices are relatively cheap or expensive. An option with higher implied volatility will be more expensive than an option with lower implied volatility,

Some traders try to profit from changes in implied volatility itself. They might buy options when implied volatility is low, expecting it to rise, or sell options when implied volatility is high, expecting it to fall. Implied volatility is a key input into many risk management models that traders and institutions use to manage their options portfolios.

## Implied Volatility and Options Pricing

Implied volatility is one of the key factors used in pricing [options](https://www.investopedia.com/terms/o/option.asp). Buying options contracts allows the holder to buy or sell an [asset](https://www.investopedia.com/terms/a/asset.asp) at a specific price during a pre-determined period. Implied volatility approximates the future value of the option, and the option's current value is also taken into consideration. Options with high implied volatility have higher premiums and vice versa.

Implied volatility is based on probability, so it's only an estimate of future prices rather than an actual indication of where they'll go. Investors consider implied volatility when making investment decisions, but this dependence can inevitably impact prices.

There's no guarantee that an option's price will follow the predicted pattern, but it does help to consider the actions other investors take with the option when considering an investment. Implied volatility directly correlates with the market opinion, which affects option pricing.

> **Important**
>
> Implied volatility also affects the pricing of non-option financial instruments, such as an interest rate cap that limits the amount an interest rate on a product can be raised.

## Options Pricing Models

Implied volatility can be determined by using an option pricing model. It's the only factor in the model that isn't directly observable in the market. The mathematical option pricing model uses other factors to determine implied volatility and the [option's premium](https://www.investopedia.com/terms/o/option-premium.asp).

### The Black-Scholes Model

This widely used and well-known options pricing model factors in the current stock price, the options strike price, the time until expiration, denoted as a percent of a year, and the risk-free interest rate.

The [Black-Scholes Model](https://www.investopedia.com/terms/b/blackscholes.asp) is quick in calculating any number of option prices, but it can't accurately calculate American options because it only considers the price at an option's expiration date. American options are those that the owner may exercise at any time up to and including the expiration day.

### The Binomial Model

This model uses a binomial tree diagram with volatility factored in at each level to show all possible paths an option's price can take. It then works backward to determine one price. The benefit of the [Binomial Model](https://www.investopedia.com/terms/b/binomialoptionpricing.asp) is that you can revisit it at any point for the possibility of [early exercise](https://www.investopedia.com/terms/e/earlyexercise.asp).

Early exercise is executing the contract's actions at its strike price before the contract's expiration. This only happens in American-style options. The calculations involved in this model take a long time to determine, so it isn't the best in rushed situations.

## Factors Affecting Implied Volatility

Implied volatility is subject to unpredictable changes just like the market as a whole. [Supply and demand](https://www.investopedia.com/terms/l/law-of-supply-demand.asp) are major determining factors. The price tends to rise when an asset is in high demand. So does the implied volatility, which leads to a higher option premium due to the risky nature of the option.

The opposite is also true. The implied volatility falls when there's plenty of supply but not enough market demand, and the option price becomes cheaper.

Another premium influencing factor is the time value of the option or the amount of time until the option expires. A short-dated option often results in low implied volatility, whereas a long-dated option tends to result in high implied volatility. The difference is in the amount of time left before the expiration of the contract. There's a longer time, so the price has an extended period to move into a favorable price level in comparison to the strike price.

## Pros and Cons of Using Implied Volatility

Pros

*   Quantifies market sentiment, uncertainty
    
*   Helps set options prices
    
*   Determines trading strategy
    

Cons

*   Based solely on prices, not fundamentals
    
*   Sensitive to unexpected factors, news events
    
*   Predicts movement, but not direction
    

Implied volatility helps to quantify market sentiment. It estimates the size of the movement an asset may take. It doesn't indicate the direction of the movement, however. Option writers will use calculations, including [implied volatility to price options](https://www.investopedia.com/articles/optioninvestor/05/020205.asp) contracts. Many investors will also look at the IV when they choose an investment. They may choose to invest in safer sectors or products during periods of high volatility.

Implied volatility doesn't have a basis in the fundamentals underlying the market assets but is based solely on price. Adverse news or events, such as wars or natural disasters, may also impact the implied volatility.

## Implied Volatility, Standard Deviation, and Expected Price Changes

[Standard deviation](https://www.investopedia.com/terms/s/standarddeviation.asp) is a statistical measure that quantifies the amount of variation or dispersion in a set of data. It's used in the context of implied volatility to measure risk in terms of the expected range of potential price moves for the underlying asset.

Implied volatility is expressed as an annualized percentage in options trading. It means that the market expects the stock price to move up or down by 20% over a year if options on a stock correspond to an implied volatility of 20%. This annual implied volatility can be converted into a daily or weekly expectation using standard deviation.

The general rule of thumb is that:

1.  One standard deviation (1SD) encompasses about 68% of the expected price move.
2.  Two standard deviations (2SD) encompass about 95% of the expected price move.
3.  Three standard deviations (3SD) encompass about 99.7% of the expected price move.

Let's say a stock is trading at $100 and has an annualized implied volatility of 20%. To calculate the expected move over the next month, you must first convert the annual volatility to a monthly volatility by dividing the annual volatility by the square root of 12. There are 12 months in a year, and volatility calculations involve taking the square root of time:

*   Monthly Volatility = 20% / √12 ≈ 5.77%

Now you can calculate the expected move for each standard deviation level:

*   1SD Move = $100 \* 5.77% ≈ $5.77
*   2SD Move = $100 \* 5.77% \* 2 ≈ $11.55
*   3SD Move = $100 \* 5.77% \* 3 ≈ $17.32

Alternatively, these calculations suggest that over the next month:

*   There's about a 68% probability that the stock will stay within $5.77 of its current price.
*   There's about a 95% probability that the stock will stay within $11.55 of its current price.
*   There's about a 99.7% probability that the stock will stay within $17.32 of its current price.

Traders can then use these standard deviation levels to help set their expectations for potential price moves and to assist in strategies like setting stop-loss levels or target prices. These are just statistical probabilities based on the implied volatility, of course. Actual price moves can and do exceed these expectations, especially in the case of unexpected events or news that significantly impacts the market's perception of the stock's value.

## Implied Volatility Example

Let's say ABC stock is currently trading at $100 per share. The market expects the company to make a significant announcement in a month that could greatly impact the stock price. As a result, the implied volatility for the stock's options has risen to 40%.

A call option on ABC stock with a strike price of $105 and one month until expiration is priced at $2.50 in the market. Using the Black-Scholes option pricing model, we can work backward to calculate the implied volatility. The Black-Scholes model takes into account the following variables:

*   **Current stock price:** $100
*   **Strike price:** $105
*   **Time to expiration:** One month (assume 30 days for simplicity)
*   **Risk-free interest rate:** 1% (0.01)
*   **Option price:** $2.50

Plugging these values into an options pricing calculator or using the Black-Scholes formula, we would find that the implied volatility is approximately 40%.

Now let's consider two scenarios:

1.  The option price will likely increase if the actual volatility of the stock over the next month turns out to be higher than 40%, assuming all other factors remain constant. The option buyer would profit from the difference in implied and realized volatility in this case.
2.  The option price will likely decrease if the actual volatility of the stock over the next month turns out to be lower than 40%. The option buyer would lose, and the seller would profit in this case.

This example demonstrates how implied volatility can be used by traders to make informed decisions. A trader might choose to sell options if they believe that the market is overestimating the potential for a significant move. The implied volatility is too high. They might choose to buy options if they believe that the market is underestimating the potential for a significant move. The implied volatility is priced too low.

## How Is Implied Volatility Computed?

Implied volatility is embedded in an option's price, so you have to rearrange an options pricing model's formula to solve for volatility instead of the price. The current price is known in the market.

## How Do Changes in Implied Volatility Affect Options Prices?

An option's price or premium will increase as implied volatility increases because an option's value is based on the likelihood that it will finish [in the money (ITM)](https://www.investopedia.com/terms/i/inthemoney.asp). Volatility measures the extent of price movements, so the more volatility there is, the larger future price movements ought to be. It becomes more likely that an option will finish ITM.

The relationship between an option's extrinsic value and implied volatility is therefore key to understanding option pricing. Extrinsic value, also known as [time value](https://www.investopedia.com/terms/t/timevalue.asp), is the portion of an option's price that isn't intrinsic. It's the difference between the underlying asset's price and the option's strike price that represents the amount an option is in the money.

Extrinsic value is directly influenced by implied volatility. Higher IV leads to higher extrinsic value, while lower IV results in lower extrinsic value. An option's [intrinsic value](https://www.investopedia.com/terms/i/intrinsicvalue.asp) is not related to IV, only to its [moneyness](https://www.investopedia.com/terms/m/moneyness.asp).

## Will All Options in a Series Have the Same Implied Volatility?

Not necessarily. Downside put options tend to be more in demand by investors as hedges against losses. These options are often bid higher in the market than a comparable upside call as a result unless the stock is a takeover target. There's more implied volatility in options with downside strikes than on the upside as a result. This is known as the [volatility skew](https://www.investopedia.com/terms/v/volatility-skew.asp) or "[smile](https://www.investopedia.com/terms/v/volatilitysmile.asp)."

## The Bottom Line

Implied volatility (IV) reflects investors' perceptions of uncertainty or risk associated with the future movements of the underlying asset. It can't be directly observed, so IV must be backed out of options prices using pricing models.

High implied volatility generally indicates greater expected price swings. Low implied volatility suggests the market anticipates relatively stable prices. Traders and investors use implied volatility to assess market sentiment, to gauge the potential risks and rewards of trading options, and to make better investment decisions.

> **Article Sources**
>
> 1.  The Options Playbook. "[What is Volatility?](https://www.optionsplaybook.com/options-introduction/what-is-volatility)"
>     
> 2.  The Options Industry Council. "[Options Pricing](https://www.optionseducation.org/optionsoverview/options-pricing)."
>     
> 3.  P.J. Kaufman. "[Trading Systems and Methods](https://www.wiley.com/en-sg/Trading+Systems+and+Methods%2C+6th+Edition-p-9781119605355)," pages 681-733. John Wiley & Sons, 2019.
>     
> 4.  The Options Industry Council. "[Exercising Options](https://www.optionseducation.org/optionsoverview/exercising-options)."
>     
> 5.  Stern School of Business at New York University. "[Chapter 5: Option Pricing Theory and Models](https://pages.stern.nyu.edu/~adamodar/pdfiles/valn2ed/ch5.pdf)." Page 6.
>     
> 6.  Sheldon Natenberg. "[Option Volatility Trading Strategies](https://onlinelibrary.wiley.com/doi/book/10.1002/9781119204473?msockid=32249ff06582668320e98bc264856760)," John Wiley & Sons, 2012.
>     
> 7.  Foot, Christopher J. "[SO9: Financial Physics; The Binomial Tree Model: A Simple Example of Pricing Financial Derivatives](https://users.physics.ox.ac.uk/~Foot/Phynance/Binomial2013.pdf)." _University of Oxford_, p. 7.