Implied volatility can be a confusing concept for investors who are just starting to trade options. While the idea of volatility is easy to understand, trying to estimate it is more difficult. However, making the effort to learn about implied volatility is worthwhile because understanding the concept can help investors determine the likely behavior of stocks over time and decide whether the prices of stock options are attractive.
What Is Implied Volatility?
Investors will often call implied volatility “IV.” The Greek letter σ, or sigma, is also used as a symbol for implied volatility. As the name suggests, IV is an estimate of the future likely movement of a given stock. Investors should not confuse IV with historical volatility, which measures the magnitude of stocks’ movements in the past. IV pertains exclusively to what analysts believe will happen in the future. Although volatile stocks can rise meaningfully, volatility is usually more closely associated with declines in stocks’ prices.
What Is Implied Volatility Used For?
Although one can use implied volatility to predict a stock’s behavior, investors typically use it to evaluate the likely future magnitude of the movement of stock options. Options give investors the right to buy or sell a stock at a specified price for a given amount of time. Investors usually purchase stock options for insurance or speculative purposes.
What Is Implied Volatility’s Relationship With Standard Deviations?
Analysts estimate implied volatility using percentages and standard deviations over a given period of time. For example, let us suppose X stock trades at $100 per share. If its IV stands at 20%, a movement of 20%, or $20 per share, over a 12-month period would be equal to one standard deviation.
There is about a 68% chance that any stock will be within the range of one standard deviation at the end of the time period for which IV is calculated. Consequently, there is a 68% chance that the $100 stock with the 20% IV will be between $80 and $120 per share 12 months from now. As IV declines, the range covered by one standard deviation narrows. If the IV of Stock X had been 10%, the range of one standard deviation would have been $90-$110 per share.
What Is Implied Volatility’s Relationship With Stock Option Attributes?
Put simply, higher volatility, sometimes called IV expansion, creates higher uncertainty about the future price action of the stock. As a result, IV expansion causes the prices of options to increase because the writers of options have a greater chance of losing a large amount of money. IV contraction, which occurs when volatility falls, has the opposite effect on option prices.
The amount of time in which an option expires affects IV. Since there is a greater chance for volatility over a longer period of time, options that expire further in the future tend to have higher IVs. Conversely, the IVs of options that expire in a short period of time tend to be lower.
To determine the volatility of an option that expires in thirty days, the implied volatility for the year is multiplied by the square root of 30 divided by 365. Of course, 30 days divided by 365 is the proportion of the year represented by 30 days. For our previous example involving Stock X, one month of volatility would be calculated as follows:
Standard Deviation = $100 x .2 x [Square Root(30/365)]
That yields a one-month standard deviation of 5.73. So there is a 68% chance of the stock trading between $94.27 and $105.73 per share 30 days from now.
What Is Implied Volatility’s Relationship With Stock Prices?
Another factor that affects the implied volatility of a stock is the demand for it. The prices and valuations of hot tech stocks such as Amazon (NASDAQ:AMZN) and Netflix (NASDAQ:NFLX) have soared in recent years. These jumps increase the chances of higher price swings in the future. As a result, these stocks have higher volatility levels. The prices of options on such stocks are usually higher. Conversely, blue-chip, slower growth stocks such as Johnson & Johnson (NYSE:JNJ) tend to move less. J&J’s lower multiple, slow growth and consistent dividend keep its stock price more stable. Consequently, the prices of J&J’s options are lower than those of Amazon and Netflix. .
Final Thoughts on Implied Volatility
Factors such as the amount of time in which an option expires and the demand for the underlying stock also can drive IV higher. Conversely, options with shorter expiration times and less volatile underlying stocks tend to have lower IVs and lower prices.
IV can help investors determine whether an option is overpriced or priced too low Although nobody can accurately predict the future, investors can use IV to anticipate stock price movements more prudently and to increase their chances of paying fair prices for options.
More volatile stocks tend to move in wider ranges. Stocks that move in broader ranges have high IVs, causing the prices of options on those stocks to be higher than those of less volatile stocks, all else being equal.
As of this writing, Will Healy did not own shares of any of the aforementioned securities. You can follow Will on Twitter at @HealyWriting.