Before we dive into implied volatility, we need to understand the concept of volatility. In simple words, volatility means that the price of an asset goes up and down. This price movement can happen for any reason, like news, policy decisions, company actions, earnings, etc.
Now let's understand what is implied volatility and what is it used for?
Implied volatility is the market’s forecast of future volatility of an asset. If more people are buying an option, its price will increase and its implied volatility will also increase. Similarly, if more people are selling an option, its price will decrease and the implied volatility will also decrease.
Implied volatility, just as the broader market, undergoes unpredictable fluctuations. Implied volatility is heavily influenced by the interplay of supply and demand. When an asset experiences high demand, its price tends to rise, causing implied volatility to increase as well. Consequently, this leads to a higher option premium due to the elevated risk associated with the option. Conversely, in situations where there is an abundant supply but limited market demand, implied volatility declines, resulting in lower option prices.
Additionally, the time value of an option, or the duration until its expiration, also plays a significant role in determining its premium. Short-term options typically exhibit low implied volatility, while long-term options tend to have higher implied volatility. This discrepancy arises from the differing timeframes until the contract's expiration. With more time available, the price has an extended opportunity to move favourably relative to the strike price.
Types of Volatility
There are two types of volatility, historical and implied. Historical volatility shows how many changes have been made in the price of an asset in the past. Implied volatility shows what the options market expects about future volatility. Implied volatility is one of the several components used to derive an option price using the Black-Scholes formula.
How can traders make use of implied volatility?
Traders can use implied volatility to understand the volatility of any asset and can also create option-selling strategies. Also, traders can plan event-based trades using implied volatility. But remember, implied volatility is a forward-looking indicator and it does not predict the direction of the options.
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