Implied Volatility
The market's forecast of future price volatility embedded in options prices — when IV is high, options are expensive because the market expects large moves; when IV is low, options are cheap and complacency may be setting in.
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What Is Implied Volatility?
Implied volatility (IV) is the volatility figure that, when plugged into an options pricing model (Black-Scholes), produces the current market price of an option. Unlike historical volatility (what has actually happened), IV is forward-looking — it reflects market participants' collective assessment of how much an asset will move before the option expires.
The VIX Connection
The VIX index (often called the "fear gauge") is essentially the implied volatility of 30-day S&P 500 options. A VIX of 20 means the market is implying annual SPX volatility of 20%, or equivalently, a roughly 1.25% daily move (20% / √252).
The key formula: Expected daily move ≈ (VIX / 100) / √252
IV vs Historical Volatility: The Volatility Risk Premium
On average, implied volatility exceeds realised (historical) volatility by 3–5 percentage points. This "volatility risk premium" is why selling options has historically been profitable over the long run — options buyers consistently overpay for insurance. However, this premium disappears violently during crises when realised vol explodes.
IV Surface: Term Structure and Skew
IV varies across strikes and expirations, creating the "volatility surface":
- Term structure: Near-term options typically have higher IV than longer-dated ones (because markets fear short-term moves more)
- Skew: Put options typically have higher IV than call options (see: Volatility Skew) — reflecting the cost of downside insurance
Practical Use
- High IV: Selling options (premium income strategy) is more attractive; market pricing in uncertainty
- Low IV: Buying options is cheap; relative cost of hedging is low; often precedes volatility spikes
- IV crush: After a known event (earnings, FOMC), IV collapses as uncertainty resolves — option buyers lose value even if the move is in their direction
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