Implied Volatility

Option prices depend on several factors, including the asset's current price, the exercise price, the time until expiry, interest rates and how much the asset's price is expected to move. All except the last can be observed directly. Implied volatility is found by working backwards from the option's market price, using an option pricing model, to calculate the level of volatility the market must be assuming.

Higher implied volatility means the market expects larger price swings, which makes options more expensive. For example, a share's options might show implied volatility of 20% in calm times, rising to 50% ahead of a major announcement, such as earnings results or a court decision, when a large price move is expected.

Implied volatility is forward-looking, reflecting market expectations, whereas historical volatility measures how much prices actually moved in the past.

Implied volatility is widely used by options traders to judge whether options are cheap or expensive. Indices of implied volatility, such as the VIX, which is based on options on the US S&P 500 index, are often called fear gauges, because they tend to rise sharply when markets fall and investors seek protection.