Implied volatility can be thought of as a reflection of the volatility in the market at a given time, rather than the actual historical volatility calculated over a certain past period.
Volatility is one of the standard variables of an option’s price.
The others (for equity options) are the underlying price, the strike (exercise) price, the time (days) until expiration, the prevailing interest rate, and dividends.
With all other factors static, higher volatility will result in higher option prices.
As a result, many traders look for high relative volatility when selling options and low relative volatility when buying options.
It is possible to determine the implied volatility by working backward from the option price, inserting all the other variables from the price of the option in an option pricing model, and “solving” for implied volatility.
Implied volatility is fairly easy to understand, but it is hard to forecast. It changes as traders’ sentiment changes and can be very susceptible to the overall market environment.
It is sometimes referred to as the “market’s current estimate of future volatility”
Implied Volatility (IV) tends to rise when traders are worried about risk or are becoming very fearful (options are seen as being overvalued).
IV will fall when investors are super-confident (options are seen as being undervalued and likely to rise in price).
A good rule of thumb is to buy options when they are undervalued (you will get them at a better price), and sell them when they are overvalued (you will be able to collect a higher premium).
Mathematically, volatility is the annualized standard deviation of returns.
This means that if you place the current price at the center of a bell curve, the probability that prices will stay within one standard deviation on either side of the current price is 67%.
In other words, the odds are 67% or better than the market will stay within the calculated price range over a period of one year.
For example, let’s say Corn currently is trading at $500 and has a volatility of 20%.
There is a 67% chance that the price of Corn will stay within a range from 20% below the current price ($400) to 20% above the current price ($600) over a one-year period.
Based on this, option sellers can calculate the premium they would want to receive for selling various Corn puts and calls.
The higher the volatility, the more likely it is that the strike price will be reached before option expiration, and the higher the premium sellers will demand.
The lower the volatility, the less likely it is that the strike price will be reached, and the lower the premium sellers will require for taking the risk of writing an option.
Usually, a decrease in price is associated with an increase in volatility. Fast markets, however, also have high volatility.