Often used in relation to options, implied volatility is a calculation that compares the current market price of a stock with the theoretical value of the market price in the future, all to predict the true value of an option. This may sound like a risky probability equation – and it is – yet it’s based on sound factual history and intelligent projections for the near future.
Once again, volatility is basically a “neutral” measurement, not an indication of a “good” or “bad” condition or decision. As a measurement (or, in this case, predictor) of “movement,” you must remember that movement may occur in either (up or down) direction. As an investor, you must consider the volatility of different securities when making decisions, particularly with options, either calls or puts.
Implied volatility can affect buyers and sellers of both types of options (put or call), therefore affecting the price you pay or receive for the purchase or sale of options. High implied volatility might cost you more on the buy or sell side, as the other party will incur more uncertainty and risk, projected or real. However, as long as you are aware of this factor, you can price your decisions accordingly, and count on the buyer/seller of the asset to do the same.
Implied volatility plays a large part in the pricing models used to sell options and until recently, the pricing of options was a largely haphazard affair of traders who came up with prices on their own…until the [ts]Black-Scholes[tm] The most generally accepted option pricing model.[te] model was developed, which we’ll look at next…