What Is Implied Volatility? Basics and Examples

Implied volatility (IV) measures how much the market expects an underlying security's price to change in the future. A higher IV means the market expects more movement in the underlying's price, while a lower IV means the market expects less movement in the underlying's price.

Importantly, IV doesn't predict the direction of a price move, only the size of potential price swings (up or down). It's a forward-looking metric that traders use to help manage risk, time entry and exit points, gauge market sentiment, select trading strategies, and determine if options are expensive or cheap. Failing to consider IV before placing a trade can lead to unexpected losses—even if the underlying moves in the desired direction.

IV is derived from an option's current market price using an options pricing model, such as the Black-Scholes model. It reflects the level of volatility implied by the current premium and is expressed as an annualized percentage, which can make the figure difficult to interpret at first.

Technically, this percentage represents the market's expectation for the underlying security's price to move by one standard deviation over a one-year period. The important part here is that one standard deviation encompasses roughly 68% of potential outcomes.

This may sound complicated, but a simple example makes the concept much easier to understand. Imagine ZYX stock is trading at $100, and an option for that stock has an IV of 20%. In this case, the IV suggests the market is pricing in a roughly 68% chance that the stock will trade between $80 and $120—plus or minus 20% of the current stock price—one year from today.

Most options traders aren't dealing with a one-year time horizon. IV can also be used to estimate an underlying security's expected price range over different time periods.

Using the previous example, suppose a trader wants to estimate ZYX's expected move over the next 30 days rather than one year. To do this, they could multiply the current stock price ($100) by the IV (20%) and then adjust for the shorter period using the square root of the portion of the year represented by those 30 days:

$100 x 20% x √(30/365) = $5.73 (plus or minus).

The calculation yields an expected move of $5.73, giving ZYX an estimated 30-day price range of roughly $94.27 to $105.73.

These expected ranges aren't predictions or guarantees. The underlying can move beyond them, and IV itself changes as market expectations shift. Still, IV can provide a probability-based estimate of how much movement the market is pricing in over a given period.

Implied volatility is just one of several factors that influence options pricing. However, all else being equal, a higher IV raises options premiums for both calls and puts, while a lower IV reduces options premiums for both calls and puts. This is largely due to how IV affects options' extrinsic value. Sometimes referred to as time value, this is the portion of an option's value that is derived from external factors rather than its inherent worth.

A higher IV tends to raise an option's extrinsic value because it means the market is expecting more price volatility in the underlying security. And greater expected price volatility effectively increases the odds of a significant move in the option buyer's favor, making the option more valuable.

Conversely, a lower IV reduces an option's extrinsic value because it means the market is expecting less price volatility in the underlying security. And less expected price volatility effectively lowers the odds of a significant move in the option buyer's favor, making the option less valuable.

One of the most common ways traders use IV is to assess whether options are relatively expensive or cheap. This can help them select trading strategies and manage risk.

To make that assessment, traders often compare IV to historical volatility, which measures how much the underlying security's price has fluctuated over a specific period (such as 20, 30, or 50 days). All else being equal, when IV is higher than historical volatility, an option is generally considered expensive. And when IV is lower, it suggests the option is relatively cheap.

Traders also gauge whether an option is relatively cheap or expensive using the implied volatility rank. This measure compares an option's current IV with its highest and lowest levels over the past year. IV rank ranges from 0 to 100. Higher readings suggest IV, and therefore options premiums, are relatively high compared to their recent history, while lower readings suggest the opposite.

Beyond assessing options premiums, traders can use IV to gauge sentiment in individual securities or broader market indexes.

A higher IV reflects more uncertainty about an underlying security's future price, which can sometimes be a sign of investor fear. On the other hand, a lower IV suggests the market is expecting more price stability, which may signal confidence or reflect complacency about potential risks.

Finally, traders also monitor IV around potentially market-moving events. Some traders even try to take advantage of IV's tendency to rise before these events and fall once they've passed. We'll dive deeper into this later.

To effectively use IV to manage their volatility exposure and risk, many traders lean on the option greek vega—which measures how much an option's price is expected to change for every 1% shift in IV.

Vega is expressed as a dollar amount by which an options premium will change and can be used to quickly determine how changes in IV will affect options pricing. If an option has a vega of .01, the options premium will theoretically increase $0.01 with each percentage point increase in implied volatility. Long options have positive vega, meaning they generally benefit when IV rises. Short options have negative vega, meaning they generally benefit when IV falls (all else being equal).

Let's walk through an example of how traders can use vega to assess options positions.

Imagine ZYX stock is trading at $100. A trader decides to execute a straddle on this stock by buying one at-the-money call option and one at-the-money put option, each at the 100 strike and with the same expiration date. Both options have a vega of 0.25, an IV of 40%, and a premium of $4.

In this case, the combined position has a vega of 0.50 (0.25 call vega + 0.25 put vega) and an initial premium of $8 ($4 call premium + $4 put premium).

As a result, if all else is equal and IV rises by five percentage points (40% to 45%), the straddle's total value would increase by $2.50 ($0.50 x 5) to $10.50 ($8 + $2.50).

Conversely, if all else is equal and IV falls by five percentage points (40% to 35%), the straddle's total value would decrease by $2.50 ($0.50 x –5) to $5.50 ($8.00 – $2.50).

This example demonstrates how IV can greatly impact a trading strategy's outcome, even when the underlying's price remains stable. Using vega, traders can gauge the potential impact of IV on their trading strategies before executing a trade.

Note: While both options have the same IV, vega, and premium in this example, these values won't always match. They are often similar, due to put-call parity, but buying pressure can lead to a put or call skew, which effectively increases the IV, vega, and option premium on one leg of the trade.

An IV crush is the sharp drop in IV that sometimes comes after a major market event, like an earnings report or a Federal Reserve meeting.

It occurs because the increased uncertainty ahead of these major market events is often reflected in higher premiums and IV. Then, once the event has passed and that uncertainty dissipates, IV can quickly drop.

An IV crush tends to hurt option buyers—even if the underlying moves in the desired direction—because it erodes the extrinsic value of their options. Conversely, an IV crush can potentially help option sellers because they can collect higher premiums prior to a market event and then profit by buying back their option at a lower price after the event, when IV drops and premiums fall.

Let's walk through two hypothetical examples to show how an IV crush can help—or hurt—a trade.

Imagine ZYX is trading at $100 and the company is expected to report earnings tomorrow. IV is high across its options as traders anticipate significant post-earnings price movement in the underlying.

Scenario 1: A long call

A trader buys an ATM call option for $7 that expires in one week and has an IV of 100%. The next day, ZYX reports strong earnings, leading its shares to surge 5% to $105. However, the call's IV also plummets to 30% due to post-earnings IV crush.

The call is now in the money and has $5 of intrinsic value ($105 – $100). However, the extrinsic value of the option sinks from $7 to just $1 due to the drop in IV and the option moving closer to expiration. As a result, the option is now worth just $6 ($5 intrinsic value + $1 extrinsic value). That's less than the trader initially paid despite the stock moving in the desired direction.

Scenario 2: A covered call

Using the same scenario, a trader holding 100 shares of ZYX sells an out-of-the-money (OTM) call at the 110 strike. Even though the option will expire in a week, the trader collects a net credit of $2, as the premium is elevated amid a high IV of 90%.

After ZYX reports earnings the next day, its stock rises 5% to $105. However, because IV plummets from 90% to 30%, the extrinsic value of the call falls to just $0.50. There is no intrinsic value in the call because it is still OTM. The trader can now buy back the call they sold for just $0.50, resulting in a $1.50 net profit ($2 initial credit – $0.50).

Note: Taxes, fees, and commissions are not included in this discussion but could impact the results of the trades.

These examples show how traders need to be aware of the impact of IV on their trades. Even when the underlying moves in the expected direction, a sharp drop in IV can reduce an option's value enough to offset gains from the move. Conversely, an IV crush can benefit option sellers as falling extrinsic value makes the option cheaper to buy back.

Trading options without considering IV is like trading with a blindfold on. IV provides critical context about an option's price and the market's expectations for the underlying. Without it, traders may struggle to properly gauge risk or make informed decisions about which trading strategies to use and when to use them.