Implied Volatility

The implied volatility is the volatility the option is actually trading at. In other words, the actual market price of the option assumes a certain volatility which is termed the implied volatility. By knowing the market price we can work backward using the Black Scholes model and determine what volatility the option is trading at for the given market price.

Many options traders use the implied volatility as the best guess estimate of the future volatility. They feel the implied volatility is the market volatility and the best estimate of the future volatility. The implied volatility can be different for each option.

Sometimes the volatilities are skewed with higher and lower strikes having different implied volatilities than in the money strikes.

There may be other reasons for the skew in implied volatilities: 

1. Many people like to buy cheap out of the money calls and puts but do not always like to sell them for the small amount of premium they receive. It is more difficult for option traders to hedge with far out of the money options so the premiums are sometimes greater.

2. The distribution of prices may affect the skew of option prices. If prices are lognormal distributed and there is a bullish bias to the market, out of the money calls should have higher premiums than corresponding out of the money puts. An out of the money call has a greater chance of being in the money than an out of the money put which is an equal distance from a future if prices exhibit lognormal behavior.

3. Some traders believe markets become more volatile as prices increase. If the volatility increases as a market moves higher and declines as a market moves lower, options should have skews reflecting this.

These are some of the reasons options sometimes exhibit skewed pricing, but there is not always complete agreement as to the importance of each factor.

The implied volatility is definitely a good start in option evaluation and deriving a good estimate of what the volatility should be. But the implieds really reflect the supply and demand situation of the option much more than as a predictor of the future volatility of the market. Let's look at an example to understand this.

Assume a market has been trading in a relatively stable way with an actual historical volatility of 20%. The implied volatilities of the options will probably be trading somewhere in the same range of 20%. An unexpected news report comes out and causes the market to soar and trade around a 40% actual volatility. The implied volatility of the options may jump to levels much greater than 40%. This may happen because many investors who were short options (and therefore short volatility) may have to buy them back no matter what the price or volatility of the option. The investors may have to buy the options back due to margin calls, severe losses, or other reasons, and not necessarily because they anticipate even higher actual volatilities.

Of course the actual market volatility may increase to even higher levels, but this does not mean that the implied volatilities accurately predicted this. Instead, the typical sellers who have just been battered now require much higher premiums and, consequently, higher implied volatilities to resume selling volatility. The same type of situation occurs when the volatility bubble collapses and premiums Implode. The buyers are now the ones who are hurt, and will not buy unless the premiums are low enough to justify reentering the market.