What is Implied Volatility?

Implied Volatility (IV) refers to the implied magnitude of potential upward or downward movements in an underlying stock's price over a year. In other words, it is the annualised expected move in the underlying's price, adjusted for the duration to expiry. Derived from the Black-Scholes model, it is denoted as a percentage and takes the stock price, expiration, etc into consideration.

For example, stock ABC is currently trading at Rs. 100 per share and has an implied volatility of 20%. This means that the market expects its price to move between the range of Rs. 80 and Rs. 120 (20% lower and higher) over the next 12 months, with a 68.2% probability of accuracy.

  • Low IV implies that the market does not expect the stock price to deviate much from its current price over the next 12 months. 
  • High IV implies that the market expects large deviations from the current stock price over the next 12 months.

A common misconception regarding IV is that it drives options prices. In reality, it is the other way around; changes in options prices allow us to find a new IV value after the change has already occurred.

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