π₯Implied Volatility (IV)
Last updated
Last updated
Implied volatility, commonly referred to as IV, is an estimate of the future volatility of the underlying stock based on options prices. It represents the market's perception of the probability of future fluctuations in the price of a specific security. By assessing implied volatility, investors can make projections regarding future movements and supply and demand dynamics. Additionally, IV serves as a crucial factor in determining the premiums of options contracts, with higher implied volatility leading to increased premiums and vice versa.
Volatility Smile:
In the Black-Scholes model, implied volatility is assumed to be constant across all strike prices, resulting in a "flat" IV curve. However, in practice, implied volatility often forms a U-shaped curve, known as a volatility smile, when plotted against strike prices. Out-of-the-money (OTM) and in-the-money (ITM) options typically have higher implied volatility compared to at-the-money (ATM) options. This smile pattern arises because the Black-Scholes model assumes constant volatility and a log-normal price distribution, which fails to fully capture market risks such as extreme price movements (fat tails) or sudden changes in volatility.
Votalitility Skew:
In real markets, implied volatility is often asymmetric, forming a skew rather than a smile. This is particularly common in equity markets, where put options tend to have higher implied volatility than call options. When plotting IV against strike prices, the curve typically slopes downward: lower strike prices (puts) show higher IV, while higher strike prices (calls) show lower IV. This reflects investors' greater concern about sharp declines in stock prices (crashes) compared to sharp rises. As a result, puts are in higher demand for hedging against downside risk, while calls often see less demand relative to supply. Implied volatility captures market fear, with puts reflecting this fear more strongly due to their protective nature.
Implied volatility is a measure used by investors to predict the potential movement in the price of a security. It serves as the market's forecast for future fluctuations in a security's price, based on certain predictive factors. Implied volatility, represented by the symbol Ο (sigma), is often considered a reflection of market risk. Typically expressed as a percentage or standard deviation over a specific time period, it provides insight into the expected volatility of a security.
In the stock market, implied volatility generally rises during bearish markets, when investors anticipate a decline in equity prices over time. Conversely, it decreases during bullish markets, when investors expect prices to rise. It is important to note that implied volatility does not indicate the direction in which the price will change. For instance, high volatility suggests a significant price swing, but it could either be upward (very high) or downward (very low), or even fluctuate between the two directions. On the other hand, low volatility suggests that the price is less likely to experience significant and unpredictable changes.
Implied Volatility Crush is a helpful indicator in the options field. Implied volatility of a contract represents the anticipated level of volatility in the underlying stock during the contract's active lifespan, up until its expiration date. During events such as earnings announcements or significant company developments, implied volatility tends to be inflated due to the expected stock movement associated with these events.
Implied volatility can be thought of as a measure of future volatility. However, once the earnings report is released, the implied volatility decreases as the market no longer anticipates a scenario where the stock will experience a significant and unpredictable price swing.
What is IV Crush and How to Make Money of It?
