Implied Volatility

implied volatility is the estimated or expected volatility of a security’s price. In general, implied volatility increases when the market is bearish and decreases when the market is bullish. This is due to the common belief that bearish markets are more risky than bullish markets.

implied volatility of an option contract is the value of the volatility of the underlying instrument which, when input in an option pricing model (such as Black–Scholes) will return a theoretical value equal to the current market price of the option.

Morningstar defines Implied volatility is a measure of the “riskiness” of the underlying security. Implied volatility is the primary measure of the “price” of an option–how expensive it is relative to other options. It is the “plug” value in option pricing models (the only variable in the equation that isn’t precisely known). The remaining variables are option price, stock price, strike price, time to expiration, interest rate, and estimated dividends. Therefore, the implied volatility is the component of the option price that is determined by the market. Implied volatility is greater if the future outcome of the underlying stock price is more uncertain. All else equal, the wider the market expects the range of possible outcomes to be for a stock’s price, the higher the implied volatility, and the more expensive the option.

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