What is implied volatility?
Implied volatility is an essential indicator used in options trading, which represents the market's expectation of future volatility based on the price of options. It can help investors to determine the potential risks and rewards associated with their investments.
How does implied volatility work?
The implied volatility indicator is calculated using complex mathematical models that take into account the current price of the option, the strike price, and the time remaining until the option expires.
A higher implied volatility indicates that the market is expecting significant price movements, which may be due to upcoming events such as earnings reports or economic data releases. Meanwhile, implied volatility tends to increase in bearish markets, which is when investors believe stock markets are likely to decline. This is because these market conditions are considered ‘riskier’ for most investors.
Conversely, a lower implied volatility indicates a lower expected price movement, and a low volatility stock has a more stable price.
How to use implied volatility for trading?
One of the most popular methods of using implied volatility is to compare it to historical volatility. This comparison can help investors to determine whether an option is overpriced or underpriced.
It is important to note that implied volatility is not a guarantee of future price movements. It is merely an indicator of the market's expectations. Actual price movements may differ from those predicted by implied volatility.
In addition, investors should be aware that implied volatility can change quickly, especially in response to unexpected events such as news releases or market shocks. As such, it is essential to monitor implied volatility regularly to stay up to date on the market's expectations.
