Implied Volatility: What It Is and How to Use It in Trading

May 05, 2022 By Triston Martin

Implied volatility is a measure of the uncertainty surrounding the future price of an asset. The higher a stock's volatility, the broader its price range over time, and thus the greater the chance it will outperform or underperform market expectations in any given period.

How is it calculated?

The implied volatility is calculated by looking at options contracts available for that particular security. For example, let's say that an option has an annualized implied volatility of 30%; it would imply that these options could be worth $1 in total or $0.30 per share one day. Still, they could also be worth exactly $0.00 if nothing changes with supply and demand for this security in that one day.

Volatility index

Implied volatility is measured on a scale of 1 to 100. The implied volatility, which is commonly known as the volatility index (VIX) on Wall Street, is often high when there is a lot of uncertainty surrounding a company or sector and the market. This uncertainty can be due to many reasons, including an analyst downgrade, news reports, or high oversold conditions.

On the other hand, if there is low uncertainty and everyone believes that the price will not deviate too far from its current level, implied volatility will be below. This is often the case with companies that have been around for a long time, have positive earnings, and are in a sector that many investors are interested in.

Implied volatility is also calculated based on data from exchange-traded products. This can be seen in ETNs or Exchange Traded Notes, traded on the Nasdaq or the New York Stock Exchange. These notes give investors exposure to assets or indexes without owning the underlying stocks.

To calculate implied volatility, simply take the annualized percentage price change and multiply it by 60. This will give you an idea of what price fluctuations may occur during any given year.

The price of an option contract is directly related to the implied volatility. If the implied volatility rises, so does the cost of the contract. The opposite is also true. If implied volatility falls, then so does the price of an option contract.

Let's take a look at some real-world examples. Let's say that there is a new technology company whose stock is currently trading for $100 per share. The stock has no debt and has been around for 50 years, making it a mature company. In addition, the company's earnings are expected to grow at 10% per year, and analysts estimate that it will earn $3.50 per share in 4 years.

Due to these factors, the stock price is expected to fluctuate very little, and traders are not really interested in owning the stock because of this uncertainty. Therefore, the implied volatility for this stock is likely to be below.

Let's say now that there is a new technology company whose stock is currently trading for $100 per share and has been around for just five years. The stock has $50 million in debt. Analysts expect it will earn $3.50 per share in 4 years, the same as above; however, the stock has not performed well recently due to the economic downturn. News reports show that a competitor's new technology may be better than theirs. With the amount of uncertainty surrounding this company and its stock, its implied volatility is likely to be high.

Implied volatility can also be affected by investor sentiment when traders make large bets on a particular sector or security. This can often translate into wider price swings for a company's stock than usual. For example, let's say that a certain company's stock has 9 analysts covering it, and the average target price is $100. The implied volatility for this stock is, therefore, 10%. If the company's CEO goes out on a stage and announces that he will be cutting costs and could possibly lay some people off, then this information would likely cause the price of this particular stock to fall because there is less uncertainty surrounding it when it is already trading in line with its peers.

It can also be said that investors are more likely to make high-risk investments when there is a high level of uncertainty; however, these increased risks will likely lead to higher returns if the investment turns out successful. On the other hand, if the investment is usually seen as risky, this will likely cause the stock price to fall because of lowered expectations for future returns.

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